San Francisco Continues to Reduce Equity Portfolio

The board of the San Francisco Employees’ Retirement System (SFERS) has terminated two investment strategies run by Dimensional Fund Advisors (DFA) due to poor performance as it continues to restructure and reduce its more than $9 billion equity portfolio.

The reduced commitment to stocks is part of an aggressive plan by SFERS Chief Investment Officer William Coaker Jr. to make the San Francisco system less dependent on public equities in order to reduce the effects of a major stock market downturn. Since October 2017, the SFERS equity portfolio has been reduced from 41% of the portfolio to 35.7%.

Coaker plans to get that down to 31% of the overall portfolio in the next year or so. While reducing equities, Coaker has also been building up alternative assets like private equity. The system’s $4.9 billion private equity portfolio now makes up 19.8% of the total portfolio, up from 13.4% in late 2016.

In the last three years, he has also built a hedge fund portfolio from scratch, which now stands at more than $3 billion, or more than 13% of the portfolio.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

As equities are reduced, poor performing managers are getting the axe.

Both DFA’s small cap US value strategy and its international small cap portfolio were terminated by the board at its March 13 meeting, a video stream of the meeting shows. SFERS had $197.7 million invested in the small cap US value strategy and $330.7 million invested in the international small cap portfolio.

The international small cap strategy has been under review by the pension system’s investment staff. The board of the $25.1 billion pension system had cut the allocation to the international strategy by $100 million in March 2018, and another $100 million in June 2018. The US strategy has not been formally under review, but agenda material for the March 13 meeting show that starting in November 2017, SFERS investment officials began to reduce the size of the strategy, which totaled almost $400 million, by $175 million.

SFERS performance numbers show that the DFA small cap US value strategy had returns of -6.6% for the one-year period ending January 31 versus -4.6% for the Russell 2000 index. For the three-year period, the strategy had a 11.8% return versus the benchmark’s 13.8%. For the five-year period, the DFA strategy returned 6.1% compared to the benchmark’s 6.6%.

The DFA international small cap strategy also had performance issues. It had a -17.1% return for the one-year period ending January 31 compared to the MSCI World ex US small cap index’s returns of -15.1% for the same time period. For the three-year period, the strategy returned 8.6% compared to the benchmark’s 9.6% return, and for the five-year period, the strategy returned 3.9% compared to the benchmark’s 4.3%.

“DFA’s overweights in the energy and industrials sectors also detracted heavily from performance,” shows a SFERS review of the international strategy contained in the March 13 agenda material. The material also noted that the international strategy missed out on the best-performing stock market segment in the fourth quarter of 2018, real estate investment trusts (REITs). It noted that the strategy had no REIT investments.

SFERS’s general investment consultant, Allan Martin of consulting firm NEPC, said he and the firm were in agreement with the terminations. He said NEPC recommends several of DFA’s investment strategies, but not the ones SFERS was invested in.

DFA, based in Austin, Texas, uses a factor-based approach to investments, aiming to enhance index returns through adding investment factors, such as weighting portfolios to smaller and value companies.

Coaker told the board that the terminations were in line with a “systematic” reductions of the system’s equity portfolio but did not publicly talk about the performance issues at DFA, though SFERS reports in the March 13 agenda material spelled out the performance issues.

Just two months ago, the SFERS board terminated money manager Fidelity Institutional Asset Management’s select international small cap equity strategy due to underperformance relative to its benchmark and other money managers. SFERS had $174.5 million invested in the strategy.

In December 2018, SFERS officials disclosed the AQR international strategy was down to $612 million after pension system officials made a $100 million reduction in June 2018. Meanwhile, officials said the William Blair international growth strategy was down to $360 million, after a $150 million reduction in March, a $100 million reduction in July, a $50 million reduction in August, and a $50 million reduction in October.

Both the AQR and William Blair strategies remain on SFERS watch list.

Another equity manager, Advent Capital Management and its $239 million balanced convertibles strategy, remains under watch because of poor performance, shows SFERS agenda documents from the March 13 meeting. The money manager could be subject to future action as the equity portfolio continues to be reduced, the documents show.

Despite the reductions in the SFERS equity portfolio, the board did hire a new manager in January, Select Equity Group. It approved a $500 million allocation to its Baxter Street strategy, which primarily focuses on international stocks.

So far, in the fiscal year that ends June 30, 2019, Coaker’s restructuring seems to be paying off. While some pension plans are seeing negative returns, he reported at the March 13 meeting overall returns of 3.3% for SFERS.

Coaker said while equities at the pension plan in the eight-month period through February 28 saw a 0.47% return, private equity returned 11.26%. SFERS modest returns aren’t being helped by the hedge fund portfolio. The portfolio posted a 0.23% return in the first eight months of the fiscal year through February 28.

Coaker has argued that the portfolio is still a good bet, because it is defensive in nature and should do better in case of a major equity freefall.

Fidelity International Small-Cap Strategy Terminated by SFERS

Tags: Dimensional Fund Advisors, San Francisco Employees’ Retirement System (SFERS), Stocks, William Coaker

T. Brad Conger

Markets offered no safe havens as volatility returned in 2018, and investors should be prepared for more of the same this year, says T. Brad Conger, deputy chief investment officer at outsourced CIO Hirtle Callaghan. Instead of getting mired in worry, however, Conger says now is the ideal time for asset owners to evaluate their portfolios and consider allocations that are better positioned for the late cycle.

Hirtle Callaghan revised its risk signals outlook in response to changes in the market toward the end of last year, shifting its US equities weighting to neutral while maintaining a positive view of emerging market equities and alternative asset classes like private credit. These investments are more active in nature but Conger says they’re also likely to perform well even if the market cools.

According to Conger, while the probability of a recession in the US remains low, US companies are likely to come under earnings pressure from slowing growth, which could disappoint investors. Against this backdrop, Conger suggests refining long-only equities strategies so that they are more selective. Hirtle Callaghan works with investment managers to create long-only equities portfolios of best ideas that have a limited number of high-conviction holdings. The approach maintains the simplicity of long-only but with a bit of an edge over simply buying the index or a generalist mutual fund that offers index-like returns. Placing a few educated bets could help to preserve capital in an environment where the broad market may not be moving in a single direction all the time.

Conger is also increasingly upbeat about emerging markets. He says companies in developing economies are exhibiting strong external balances, positive current accounts, and a “valuation gap that is more attractive than it has been in the past.”

For more stories like this, sign up for the CIO Alert newsletter. 

Risk Assets Aren’t All Bad

According to Conger, a cultural shift is underway at smaller endowments, foundations, pensions, and family offices that is driving changes in how these organizations manage their portfolios in response to the uptick in volatility. “There’s a growing recognition that the portfolio needs to be more responsive to market events that happen between quarterly meetings,” he explains. That recognition is increasing demand for risk assets. “Allocators understand that because they aren’t time constrained in their investment process, they can hold more illquid investments and realize the higher premiums that come with them,” Conger says.

Hirtle Callaghan is working with allocators to position portfolios so that they are able to take advantage of tactical opportunities that arise out of volatility and add unique exposures. “We had some clients do well with investments in European distressed debt last year and other parts of the private credit space,” Conger says. “When you’re running a small endowment of say $100 million, a single private credit opportunity can be very meaningful to the portfolio, creating a differentiated source of outperformance. Giant pension funds are going to have a hard time investing in the same way because the opportunities are too small. Those are the kinds of scenarios we’re working through with our clients now that the market is starting to shift.”

Related Stories:

Hirtle Callaghan Hires First CIO

Hirtle Callaghan Creates New Client Engagement Role

Tags: Brad Conger, Hirtle Callaghan, Private Credit