The San Diego City Employees’ Retirement System always likes to brag about its investment performance. It endlessly points out that among its peers (other municipal employees’ funds) and among benchmarks by which various funds are measured, it is in the top 5 percent, or 3 percent, or whatever.
Those bragging rights are going down the toilet. The city employees’ pension fund had an utterly dismal performance in the third quarter of 2008, ended September 30. Over the past quarter, the past year, and the past three years, it is now doing poorly when compared with benchmarks.
In the fall edition of Free Spirit, the pension system’s newsletter, the deputy chief investment officer boasted that through June 30 of this year, the fund had risen annually by 7.77 percent, 10.7 percent, and 7.95 percent over the past three, five, and ten years, respectively. The ten-year performance was in the upper 3 percent among peers, boasted the fund.
But that was for June 30. Its record for the third quarter of this year, ended three months later, changed the picture. The fund lost 10.10 percent in that third quarter; other municipal funds, on average, lost 7.28 percent. This put the San Diego fund’s performance in the lowest 14 percent that quarter.
These abysmal results then shifted all the numbers downward. Over the past year, the fund lost 15.62 percent, putting San Diego’s return in the lower 34 percent of comparable pension systems. For three years, the return is 2.47 percent a year — ranking in the lower 43 percent. Annual performance over five years is now 7.34 percent. Ten-year performance is still very good — 7.65 percent a year, in the top 6 percent. The losses will be worse after the fourth quarter, which is not yet finished; the overall stock market has suffered a monumental bloodbath in 2008.
The latest numbers can be found in the third-quarter report by Callan Associates, a consulting firm that does statistical analyses for the San Diego City Employees’ Retirement System (SDCERS). “In a terrible quarter and year in the capital markets, the SDCERS portfolio underperformed peers,” says Callan’s Janet Becker-Wold, although pointing out that the ten-year returns remain outstanding.
In the third quarter, the various components of the San Diego fund — domestic stocks, international bonds, etc. — did worse than comparable funds. To put this in context, it’s necessary to look at the fund’s history. In the giddy days of the mid-1990s, the portfolio managers got gamier. Up until then, 55 percent of the fund was in U.S. fixed income securities (basically bonds). Just 35 percent was in U.S. stocks and 10 percent in real estate.
In late 1994, the bond portion was reduced to 36 percent (34 percent U.S. and 2 percent foreign). Stocks were raised to 54 percent (41 percent U.S. and 13 percent international). But the broad stock market, both domestic and foreign, has gone nowhere since 1998, and there have been two bad bear markets, 2000–2002 and the current one, in those ten years. So the pension fund boosted its pursuit of stocks just in time to get in on a dismal decade. Its ten-year record is quite good but probably could have been better if it had stayed more conservative.
But in the mid-1990s, the San Diego pension fund was merely following the herd: other pension and charitable portfolios loaded up on stocks at that time on the notion that they do better over the long haul than bonds. Reliable statistics show that has been true, but conservative investors warn that a heavy concentration in stocks can be dangerous. In 2006, the allocations were tweaked to stocks 55 percent (38 percent domestic and 17 percent international), bonds 34 percent (30 percent U.S. and 4 percent foreign), and real estate 11 percent.
In this year’s bleak third quarter, the pension fund underperformed in just about every category. U.S. stock plunged 10.8 percent versus the benchmark’s minus 7.4 percent, winding up in the bottom 12 percent among peers. International stocks plunged 22.9 percent, ranking in the bottom 10 percent among peers. Domestic bonds, dropping 5.3 percent, did twice as poorly as the average fund. Foreign bonds were down 6.29 percent and in the bottom 17 percent. So-called market-neutral funds, which take both long positions (betting on an upride) and short positions (gambling on a downride), dropped in value and collectively were deep in the bottom half. Returns on real estate (which are reported a quarter behind the other assets) were in the bottom 21 percent; one real estate investment trust portfolio fund, losing 9.52 percent for the quarter, was at or below the bottom 1 percent for both the quarter and year.
I asked San Diego City Employees’ Retirement System about the rancid third-quarter performance. A spokesperson said that the underperformance of U.S. stocks was “primarily due to unprecedented volatility.” Some categories of stocks, such as cosmetics makers, will perform well one day and the next day the steels will do well while cosmetics plunge, complained the pension system. Yeah, but all pension funds faced those same conditions. Response: “In the current market environment, fundamentals don’t seem to matter in the market, and investment managers with a focus on higher-quality stocks, like SDCERS, may underperform.”
But does the San Diego pension system really have higher-quality stocks? Callan, for one, has challenged the system’s stock allocation. There are large-capitalization stocks, those that the market values at $10 billion or more. There are mid caps, $2 billion to $10 billion. And small caps, $300 million to $2 billion. Callan told the City’s pension system in June that the overall market distribution was 84 percent large cap, 8 percent mid cap, and 8 percent small cap. But San Diego’s pension system has 60 percent large cap, 20 percent mid, and 20 percent small — a much heavier concentration in more speculative small- and mid-cap stocks. Callan conceded that these non–blue chips have a better record in recent years but warned that there have been “long historical periods during which mid- and small-cap stocks have underperformed large-cap stocks.” San Diego should consider shaving its allocations of these gamier small- and mid-cap stocks, lest it lock in some losses, said the consultant.
According to Russell Investments, which rides herd on investment performance, mid-cap stocks dropped 10.18 percent in November, while the broad market went down 7.89 percent. Mid caps have done worse than the broad market for the past three months, one year, and three years. Small caps have underperformed the broad market in November and in the past three months. In November, small caps dropped 11.8 percent while large caps dropped 7.6 percent — a significant difference. Small caps suffered “staggering losses” early in the month, said Russell.
But the San Diego pension system is not budging: “Given SDCERS’s belief that small and mid cap stocks will outperform large caps over long time horizons, there is no plan to change the allocation at this time,” says the pension system in a statement.
That could prove risky.
The fourth-quarter results won’t be reported until February. Small- and mid-cap stocks are looking more feeble than the overall market, which is plenty weak. It will be interesting to see if the fourth quarter’s performance justifies the pension system’s cockiness.
The board held various meetings in the December 17–20 period. It was told that as of October 31, the fund balance had dropped to $4.68 billion from $5.94 billion a year ago. The pension system’s actuary, Cheiron, reported that because of the investment climate, the coming year “will be most challenging and these extraordinary times mandate some discussion in coming months.” Hmmm.