NO, This Pension Fund is NOT Daytrading Your Retirement Funds, With Up to 500% Leverage

Sometimes, the real story gets sacrificed to the gods of good headlines.  This is an excellent example.

I recently came across an an article with the headline “This Pension Fund Is Daytrading Your Retirement Funds, With Up To 500% Leverage.”  It linked through to the article from Pension360 entitled (only slightly less sensationally) “Is This Pension Fund Day Trading With Its Portfolio?“

Just reading the headlines is enough to make you shiver.  Just about everyone already knows that the number of pensions has been in steady decline for decades, and the ones that remain are increasingly experiencing funding shortages and almost insurmountable liabilities.  Against this backdrop comes the above headlines of some catastrophically misguided lunatic who thinks it’s a good idea to wager pension funds on the investment equivalent of a roulette table…

…while taking out a marker!

Except it turns out that’s not what’s going on at all.  Let’s take a look at the major complaints in these articles – which are referencing the San Diego County Employees Retirement Association (SDCERA) – and dissect them one-by-one.

SDCERA is day-trading.  This is true, but it’s probably not what you’re imagining.  Pension funds are the behemoths of the investing world.  As of the end of FY2013, the SDCERA had over $9 billion.  The largest equity holding at the time (Enterprise Products Partners) accounted for almost 500,000 shares with a value near $31,000,000.   If the fund wanted to make the dramatic move of selling every share, do you think they could do it in a single day without adversely impacting the price they received?  Of course not!  So, imagine that they might take a week, or a month, or even more in extreme cases, to scale out of an investment…and then realize that they have exposure to thousands of investments in their portfolio.

They trade every day, but they are not “day trading.”

“More leverage” equals “more risk.”  This is one of my favorite myths to debunk, and as it seems that SDCERA is employing a “risk parity” approach, it’s apt.  Without going too far into what risk parity is or the multitude of risk parity approaches (note: we’ve covered risk parity extensively before, the simplest explanation is that risk parity seeks to find the most diversified portfolio possible, and then scale exposure to this portfolio to target a required return. Where the unlevered expected return on this uber-diversified portfolio is lower than the required return, the portfolio would incur leverage to increase exposure to a level that is expected to deliver the required return.

This may seem risky except when one considers the alternative (and more common) method of engineering a portfolio to achieve higher returns: heavily concentrating the portfolio in equity risk. Which begs the question, would you rather have leveraged exposure to an extremely diversified basket of global asset classes, or unleveraged but highly concentrated exposure to one major source of risk? We know which approach we would choose.

SDCERA had a gross return of 13.4% for FY2013 while CalPERS returned over 18%. Again, this is true yet misleading.  We can start with the fact that SDCERA invested only 25% in public equities while CalPERS invested 51% in that asset class.  That alone is enough to dismiss fully any sort of meaningful performance comparison, but when combined with the “how to use leverage to achieve risk parity” point above, SDCERA’s strategy seems downright prudent compared to CalPERS.

I can understand the public outcry against a pension fund day trading with 500% leverage and inevitably underperforming peers.  That would be an egregious breach of fiduciary duty.  But that doesn’t appear at all to be what’s going on here.  As far as I can tell, what’s happening here is a relatively well-funded pension is taking a responsible approach to risk management using prudent amounts of leverage to meet funding targets

Of course, nobody would read an article with the impressively boring title “Pension Responsibly Manages Assets With Keen Eye Toward Fiduciary Obligations.”