How do you rebalance when the economy is so unbalanced? That is the question facing all money managers and particularly the fiduciaries that run pension funds for employees. Periodically — say, once a year — the pension fund boards “rebalance” their portfolios, deciding how much will go into stocks, bonds, real estate, and other investments. They try to assess the economic future and figure how various investment strategies will be optimal for the long run.

The board of the San Diego City Employees’ Retirement System has just completed its annual look into the crystal ball. The board made almost no strategy changes. That could have been a mistake.

Until the mid-1990s, 55 percent of the portfolio was in bonds — a conservative strategy. Only 35 percent was in stocks then and 10 percent in real estate. In late 1994, the pension system decided to reduce bonds to 36 percent and raise stocks to 54 percent. Despite two debilitating bear markets in stocks in the last decade, the pension system has stuck with roughly that allocation.

The fund’s target, for now, is for U.S. stocks to be 38 percent of the portfolio and foreign stocks 17 percent. But for the period ended March 31, U.S. stocks in the portfolio are down 37.75 percent in the last year, down 14.81 percent in the last three years, and down 4.38 percent in the last five years. Foreign stocks are down 46.27 percent in the last year, down 14.24 percent in the last three, and down 1.03 percent for the last five. By contrast, U.S. bonds are down 7.25 percent in the last year but up 2.79 percent over three years and up 3.24 percent over five years.

The total fund looks for a yearly annual return of 7.75 percent. But over the last year, the fund has been down 27.67 percent. Over three years it has been down 7.29 percent. Over five it has been up a meager 0.14 percent and over ten years up just 4.18 percent. Those percentages will rise when second-quarter figures come out after June 30, but they won’t go up by that much. Generally, the fund has been underperforming or barely keeping up with its peers, except for the ten-year return, which has been very good, compared to other funds.

While the fund was pondering its allocation this year, its consultant, Callan Associates, sketched out nine different scenarios for the board to consider. Under five of those scenarios, the bond portion would be sharply raised and stocks lowered. In one, stocks (both domestic and foreign) would go down to 31 percent and bonds up to 44 percent — a conservative allocation. In all but two of the scenarios, stocks would be below 50 percent.

But the board stuck with stocks. They remain above 50 percent, and bonds have only been nudged up a bit. William Sheffler, who recently left the board, says that for most portfolios, he prefers the conservative bond-heavy route. But the City’s benefits schedule is very inflation-sensitive. For example, benefits are adjusted for inflation. “If we had inflation, benefit liabilities would start skyrocketing, and bonds wouldn’t keep up,” says Sheffler. “We need a decent equity component.” (Bond prices go down during inflation periods, but stocks are likely to suffer too. And bond maturities can be laddered so the instruments are maturing as workers are retiring.)

In the second half of this year, 5 percent of the fund will go into private equity. That’s the purchase of assets that are not listed on exchanges or the purchase of listed companies, taking them private, loading them with debt, and bringing them public again. The board has been working on this for eight years but could be plunging in at just the wrong time. The big private equity firm Kohlberg Kravis & Roberts lost $1.2 billion last year. The board has decided against going into commodities and against raising its 11 percent stake in real estate to 15 percent. “That’s too high,” says Sheffler.

I interviewed San Diego market pros about asset allocation in this miserable environment; they weren’t reflecting on the San Diego City Employees’ Retirement System. Some believe that the economy is not turning around. The stock market rejoices when some statistic is slightly less awful than a year ago but ignores the bad news. Del Mar’s Arthur Lipper, who has been watching markets and the economy for more than 55 years, says that the government’s hurling money at the problem won’t boost the stock market. “I am and remain skeptical,” says Lipper, questioning whether consumer and capital spending, residential and commercial real estate, and exports can get any traction. Pension funds should strive for “the preservation of capital, not the enhancement of capital.” If a fund buys stocks, it should sell options against those it owns to enhance income. He prefers Canadian financial instruments to those denominated in the dollar. He would go into commodities — particularly gold.

E. James Welsh of Carlsbad’s Welsh Money Management notes that some government statistics are pumped up artificially, and the market is jumping on the supposedly encouraging news. For example, the Labor Department grossly overestimates jobs that have been gained in small business. Actually, the nation has lost many more jobs than have been reported. Stocks hit a low in March and then staged a rally. “That low in March was not the end of the big bear market,” he says. It’s possible the economy won’t come back, and stocks could see those lows again. He thinks bonds are fine if their maturities are structured to correlate with retirements. He doesn’t like real estate. “Commercial real estate will be down for another year to 18 months, and housing is two or three years from the bottom,” says Welsh.

Michael Stolper of Stolper & Co. doesn’t like real estate. “It provides far greater benefits to the people who promote it than the people who own it. It doesn’t favor passive investors,” he says. Private equity is risky: sometimes great but often poor. Stolper believes there will be a recovery and likes stocks. “If you can stand the heat, it’s crazy not to tilt toward equities. They are much cheaper than they were 18 months ago.” History says that’s the time to buy, he says. He points out, however, that for many years scholars have agreed that over long periods (say, 200 years) stocks have provided a better return than bonds. Now, however, some double-domes are challenging that thesis. If bonds have done as well as or better than stocks through the years, then a rethinking is in order, he says.

Neil Hokanson of Solana Beach’s Hokanson Associates likes the predictability of high-quality bonds. However, quality stocks are paying good dividends now; he wouldn’t argue with a portfolio that is 50 percent in equities. He likes commodities. “If a committee is concerned about inflation, commodities would be one tool in its quiver,” says Hokanson. He has a problem with venture capital, hedge funds, private equity funds, and the like. “The trouble is opacity. If you don’t know what is going on and don’t understand it, you are gambling with investors’ money.”

Welsh thinks a pension fund should constantly re-evaluate its portfolio — not set targets once a year or so. “We will probably be in a volatile environment for the next five to ten years. It will be so unpredictable, the only constant will be staying on your toes and being flexible — not being married to one scenario,” he says. “So the fiduciary of a pension fund should look at asset allocation on a regular basis.”

Listen to Don Bauder discuss this further on Reader Radio.