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Outsourced CIO Failure at San Diego County Pension Fund

Salient Partners’ abrupt exit from SDCERA is a case study on the importance of cultural fit in outsourced pension investment management.

San Diego County’s five-year experiment with an outsourced CIO officially and abruptly ended on July 16. That’s when the nine-member board of trustees at the county’s pension fund voted unanimously to terminate its asset management contract with Salient Partners. Given that the San Diego County Employees Retirement Association had already replaced Salient CIO Lee Partridge with new, internal CIO Stephen Sexauer on May 29, this final blow effectively severs any relationship with the Houston-based firm that had been managing nearly half of the fund’s $10.6 billion in assets.

“Make no mistake, we were interested in terminating this contract,” confirms Dan McAllister, the only popularly elected trustee by virtue of his position as county treasurer. “The informal timetable suggested by [SDCERA consultant] Verus was November 1. [County supervisor] Dianne [Jacob] and I stepped forward and said, ‘Let’s get on with this business.’”

“This business,” as McAllister calls it — a cautionary tale for public pension plans, as others might frame it — involves a five-year journey in which Partridge went from favored son to unloved outcast. Along the way, the once-enthusiastic board of trustees changed from unanimous approval of a 20 percent risk parity allocation to total rejection of the strategy. Significant events in this drama include relentless criticism from writers at the San Diego Union-Tribune, the departures of key Partridge advocates from the board and calls from outside governance consultants to bring investment management back in-house.

The last straw for McAllister and Jacob was Standard and Poor’s credit downgrade of Salient from BB– to B+ on June 8 and, on June 11, Moody’s Investors Service’s outlook reassignment from stable to negative, based on the investment firm’s decreased access to the credit markets during its acquisition of Forward Management. Although analysts from both rating agencies confirmed with Institutional Investor that their changes were not material to equity investors or SDCERA, McAllister and Jacob asserted that Salient did not provide advance notice of the rating changes. Salient, for its part, sent SDCERA interim CEO David Wescoe an e-mail early on June 15 informing him of the changes regarding the firm’s credit rating and suggesting that they have a call to discuss the changes.

The Salient e-mail was too little, too late for McAllister and Jacob, who wrote in a June 17 letter to Wescoe, “We recommend that you provide the Board with an accelerated action plan (during the July 2, 2015 SDCERA meeting) outlining your recommendations towards severing all professional ties with Salient Partners.” (Wescoe, a former CEO of the neighboring San Diego City Employees’ Retirement System, was hired as a governance expert by the SDCERA board last year, while Brian White was CEO. When White left, after 18 years in the job, Wescoe became interim CEO.)

Partridge’s departure has a familiar ring to it. It seems like only yesterday that the SDCERA board was clamoring for Partridge’s investment expertise as he was exiting his eight-year position as deputy CIO of the Teacher Retirement System of Texas. The pursuit came about after the March 2009 resignation of another once-favored son, SDCERA CIO David Deutsch, following the blowup of a fund manager he had selected, WG Trading Co., after allegations of conspiracy and securities fraud. To get Partridge on board at a higher salary than they were able to match, SDCERA trustees worked out a special arrangement in which he would create a one-man advisory firm, Integrity Capital, and operate as an outsourced CIO within the San Diego office. Partridge and his family moved from Austin to San Diego, and at first all went well.

But the OCIO arrangement began to change in November 2010, when Partridge’s shop was acquired by Houston-based Salient Partners. The outsourced CIO moved back to Texas to run the investment office remotely. The board began to feel the loss of an on-site CIO, but with faith in Partridge’s investment management prowess — and his knowledge of hedge funds and other complex investment strategies — they remained satisfied with the OCIO arrangement. But with Partridge’s introduction of a Salient-run risk parity strategy in 2014, the tide began to turn against him.

Risk parity, a 20-year-old strategy developed by Bridgewater Associates founder Raymond Dalio, uses leverage, or borrowing, to enhance returns on low-risk assets like fixed income. After several SDCERA board retreats and educational sessions with risk parity managers such as Bridgewater and AQR Capital Management, the board voted 9-0 in April 2014 to adopt a risk parity strategy run by Salient rather than use outside managers, in large part because of Salient’s fee advantage. SDCERA’s Seattle-based consultant Wurts & Associates (later rebranded Verus) had recommended splitting the allocation between Salient and a second manager. But the allocation was not to be long-lived.

The San Diego Union-Tribune, which had long critically covered SDCERA, seized on the dangers of using leverage in the risk parity portfolio. Columnist Dan McSwain published 17 articles on Salient’s investment decisions. In an August 9, 2014, piece, “County bets all-in at pension casino,” he wrote, “This basic life lesson, to risk only within your means, has somehow escaped the people who oversee San Diego County’s public pension system.” He went on to accuse Salient of reaching for yield by injecting greater risk into the portfolio, in part to make up for an unfunded liability that was $2.45 billion in the 2013 fiscal year.

McSwain implied that SDCERA wasn’t in control because of the outsourcing arrangement and made an issue of Partridge’s earnings compared with those of his predecessor Deutsch. At first, the SDCERA board wrote a rebuttal, which was published on the Union-Tribune website. “Before all the tumult started in late July-August [2014], when discussion was held about risk parity, [the board felt] leverage was the right way to go,” says treasurer McAllister. But as the negative reporting continued, the trustees stopped trying to defend their actions in print.

SDCERA, like other large public pension funds, has a long history of public scrutiny. Past criticism included negative assessments of former CIOs Deutsch and Richard Rose’s strong bias toward complex investment structures such as risk parity and portable alpha, a technique that involves hedge funds and derivative products like futures.

Despite the arrows that have been flying, the fund’s performance has been good. For the five years Partridge served as CIO, the fund generated an 8.8 percent annualized net return, which translated to a $4.1 billion gain for plan members. In 2014 the SDCERA fund ranked in the 7th percentile of public pension plans with more than $1 billion, as measured by the Wilshire Trust Universe Comparison Service annual ranking. But good performance was not enough to save Salient’s mandate.

The fact is that while the most-sophisticated investors at corporate pensions and university endowments have long made use of arcane investment strategies like portable alpha and risk parity, the stewards of public pension funds have found it difficult to embrace hot-button concepts like leverage and hedge funds under the bright lights of public scrutiny. For example, the well-regarded State of Wisconsin Investment Board tried at length to build its own risk parity portfolio but failed because of negative public opinion.

Sexauer, SDCERA’s new CIO, believes that “the decisions by the fund to go the outsourced route or risk parity are completely legitimate decisions.” SDCERA executed the decisions well, he adds, but the board came to realize that the combination of complexity and leverage wasn’t going to be right for them.

It wasn’t just the investment strategies that did Partridge in. His relocation nearly 1,500 miles away did not wear well long-term. And unlike many smaller funds, in the view of some pension observers, SDCERA has both the asset size to require full-time in-house oversight and the ability to obtain an experienced professional willing to take that on. That was the conclusion of two governance consultants, Wescoe and Toronto’s Cortex Applied Research, that were hired to deliver their views late in 2014.

“When you outsource the CIO, you also bifurcate management of the organization,” says Wescoe, president of Efficient Market Advisors in San Diego. “The CIO should be an important part of the management team.” What is more, Cortex made clear, a linear governance structure in which the CIO reports to the CEO rather than directly to the board is a preferred method, used in most corporate settings. Partridge had been reporting directly to the board. Wescoe, an attorney and former CEO of two other pension funds, explains that in September 2014 the California Public Employees’ Retirement System revised its executive management reporting structure to reflect that the board will have only one direct report: the CEO. Both will be responsible for hiring and firing the CIO.

In an e-mailed statement to Institutional Investor, Partridge writes, “We believe an effective OCIO model is one that provides the appropriate support and resources to equip a client with investment processes, procedures, oversight and strategies that will meet or exceed the client’s stated objectives — all of which we put in place for SDCERA.”

Wescoe disputes the idea that a good CIO is hard to find or requires an outsourced solution such as followed Deutsch’s departure. “These are incredibly important and desirable positions,” he says of large public pension investment officers. “You manage a lot of money, you have access to the best money managers in the world, and you have a lot of clients who are placing their trust in you — 40,000 people at SDCERA.”

Treasurer McAllister is happy about the CIO job’s homecoming. “It’s moving from Texas to its rightful place in California,” he notes. With a new CIO in place, perhaps this time around, as it begins to create a new investment policy and asset allocation later this summer, the SDCERA board will finally give up its ambivalent relationship with sophisticated investments and go for a plain-vanilla portfolio.

Follow Frances Denmark on Twitter at @francesdenmark.

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