Which is riskier: Warren Buffett or pension fund

Is San Diego County’s use of derivatives and leverage comparable to Warren Buffett’s? Not by a long shot.

Yet that’s the latest theory from Lee Partridge of Salient Partners, the consultant who engineered the new investment strategy for San Diego County’s $10 billion pension fund.

Partridge invoked history’s greatest investor in a Sept. 4 presentation designed to calm down nervous board members.

Under a revised investment strategy that took effect July 1, managers can use derivatives to put $20.5 billion or more at risk in financial markets, using the fund’s $10 billion in assets as collateral.

Last year, managers were limited to the equivalent of $13.5 billion in market exposure, a figure that already placed the fund among the nation’s most highly leveraged.

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“Frankly, it scares the heck out of me,” said Dianne Jacob, a county supervisor and appointed member of the pension board. Jacob joined the board’s unanimous vote in April approving the strategy, but now she’s clearly having second thoughts.

Partridge’s response this month essentially went like this: Buffett uses derivatives and leverage, too, so there’s little need to worry about rising risk to taxpayers and retirees. Indeed, Partridge gave information purporting to show that the county’s fund is less leveraged than Berkshire Hathaway, Buffett’s investment vehicle.

This was an inspired idea, but not in the way Partridge intended. Instead, comparing his strategy with Buffett’s has exposed just how rapidly San Diego County is embracing risk.

Let’s start with a basic principle. Buffett avoids any investment he doesn't understand.

This idea became famous in 1999, when Buffett was taking heat for refusing to buy into technology companies, especially those without earnings. When the bubble burst in 2000, damaging values beyond the sector, he scooped up great companies at depressed prices.

Now flash forward to March 2013, to one of the most intellectually bizarre public meetings I've ever attended.

Speaking at a board retreat, chief counsel Steve Rice discussed how board members who didn't understand Partridge’s strategy must still uphold their moral and legal responsibility to protect retirees.

Unlike a traditional pension fund manager, Partridge wasn't buying stocks and bonds, and then holding them for years. Instead, he was placing complex bets on future price movements, using futures, forwards, swaps and other derivatives.

And yet, using elaborate calculations, he was telling the board that his strategy offered higher returns at lower relative risk than traditional pensions.

Several members confessed to being lost in a maze of standard deviations, Sharpe ratios and other high-level math.

Only a lawyer could love Rice’s advice: Under California law, members are on the hook if they don’t understand a bad strategy and approve it anyway, based on the advice of experts — but they are also responsible if they reject the strategy if it goes on to do well.

So far, they have chosen complexity over comprehension.

One reason is that Partridge’s view of risk has been endorsed by Scott Whalen of Wurts Associates, an independent consultant. Wurts is a competitor of Partridge, but it also sells investment outsourcing to pension boards and advocates similar trading strategies.

Although common on Wall Street, the Wurts/Partridge view of risk is far from settled science. It measures risk according to “volatility,” or how far the price of an asset swings.

This is useful if you are betting on price movements. If your index drops 10 percent in the month a leveraged derivative expires, you could be wiped out. But let’s say it rises 10 percent. Woo hoo! Taking more volatility really paid off.

“Nonsense,” is how Buffett describes this theory. That’s because he only buys shares of companies that have earned money over many years.

So he doesn't care if IBM shares suddenly fall 20 percent. It’s still paying dividends each quarter. Time to buy more.

Let’s say IBM quickly recovers, and gains 20 percent from his original cost. This strong upward movement would jack up its volatility statistic. Try telling Buffett that his 20 percent gain was “risky.”

But modern risk managers see any volatility — even the woo-hoo flavor of upward volatility — as risk. Indeed, Partridge has moved the county’s pension fund away from stocks into allegedly less-risky leveraged bets on bonds, commodities and other asset classes.

This brings us to Partridge’s “me-too” moment with Buffett, in which the former claimed that Berkshire’s portfolio is leveraged by more than 300 percent, while the county fund’s may rise to 105 percent.

Partridge’s figures are wrong on one point: He puts Berkshire’s investments at $106 billion in 2013, whereas federal filings put it at $118 billion, out of $485 billion in total assets.

And a recent paper published by economists at the AQR hedge fund (which manages some county investments), estimated Berkshire’s average leverage at 60 percent over the years.

More to the point, such leverage represents mostly cost-free “float” capital from Buffett’s insurance companies. This is what insurance companies do for a living; safely invest premiums from policyholders until they need it to cover claims.

Consider the contrast to Partridge’s strategy. Suppose a sharp jump in interest rates causes global stock and bond markets to plunge. Falling derivative prices would trigger margin calls, either forcing asset sales or hitting the pension fund’s $4.8 billion in collateral.

Of course, Buffett is also subject to market downturns. But nobody can force him to sell, unless at the same time a natural disaster destroys, for example, enough cars insured by his Geico subsidiary to require more liquidity.

San Diego County is speculating, using public money and leverage to bet on price movements in volatile markets.

Buffett is investing, making relatively modest use of cash that is insulated from volatile financial markets. And he has been beating market averages for 54 years.

To borrow from the late Sen. Lloyd Bentsen, it seems that Lee Partridge is no Warren Buffett.