San Diego County’s public pension fund is exploring alternative legal structures to eliminate the risk that catastrophic losses could wipe out its leveraged portfolio and leave taxpayers with billions of dollars in debt.
At a contentious meeting Thursday, the pension fund’s board directed managers to fence in potential losses without reducing expected investment returns.
Under a revised investment strategy that took effect July 1, managers can use derivatives to put $20 billion or more at risk in financial markets, using the fund’s $10 billion in assets as collateral.
“Frankly, it scares the heck out of me,” said Dianne Jacob, a county supervisor and appointed member of the pension board, said Thursday.
The fund’s chief investment strategist, Lee Partridge of Salient Partners, said the probability of total losses was exceedingly low. The view was echoed by the fund’s chief executive and a consultant charged with risk management oversight.
Board members approved the new strategy in April, by a unanimous vote that included Jacob.
The decision nearly tripled the explicitly allowed use of leverage, a form of borrowing, and directed Partridge to diversify investments in hopes of boosting returns while managing risk.
However, the board has since been weighing an investment policy statement to spell out leverage limits and oversight, and some members have expressed increased concerns about the risk of losses.
“The draft IPS does not include appropriate limits and board approval processes in the areas of asset allocation, leverage and portfolio risk monitoring,” said county Treasurer and board member Dan McAllister, in a letter given Thursday to the fund’s chief executive, Brian White.
The point was driven home by Samantha Begovich, a county prosecutor who joined the board in July.
Holding up a dollar bill, then adding a second dollar bill, Begovich asked directly whether the fund could lose its entire balance — and still owe $10 billion.
That’s “absolutely true,” said Scott Whalen of Wurts Associates, the consulting firm hired by the board to monitor investment risk.
Partridge said the probability of total loss was close to zero, a view endorsed by Whalen and White.
Yet when Jacob asked Partridge to specify the probability, he said, “That’s not something I can measure on my calculator.”
He also said the strategy relies on spreading investments widely across asset classes to manage risk, and does not make use of “stop loss” contracts or other hedging tactics.
“We have not found a way to reliably limit losses” while also fulfilling the board’s risk and return expectations, Partridge said.
However, the county fund’s revised strategy would have outperformed traditional pension portfolios in a variety of “stress tests” of market conditions, ranging from the 1973-’74 oil crisis to the 2008 financial panic, according to an analysis performed by Whalen.
In a presentation describing the fund’s use of leverage, Partridge said his strategy sticks to derivatives in large markets that are easy to trade, reducing the county’s risk of a liquidity crisis.
“In periods of high volatility, we automatically reduce exposures,” he said.
Board members seized upon a suggestion by White that investments could be made through a “pooled” fund, limited partnership or other legal investment vehicle. The purpose would be to cut the fund’s potential losses to its original investments, shifting risk in an unspecified way.
Partridge suggested Salient would be willing to act as general partner in such an arrangement, and “take on the contingent liability.”
In a separate discussion, several board members questioned a contract extension that would briefly boost Salient’s fee to $11.4 million a year from roughly $10 million a year.
The fee actually represents a discount from a previous board-approved contract, set to take effect Oct. 1, said Steve Rice, the fund’s chief legal counsel.
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