Three Managers Put Under Review By San Francisco Pension Plan

Investment staff of the $24.4 billion San Francisco Employees’ Retirement System (SFERS) has added three money managers running international equity strategies to its managers under review watch list and has been gradually reducing their allocations because of poor performance.

Investment staff documents dated Dec. 12 show that the AQR international strategy, the William Blair international growth strategy, and the DFA international small cap strategy were all added to the managers under review list.

Four other managers’ investment strategies were already on the list: Advent Capital’s balanced convertible strategy, the Fidelity international small cap strategy, Oaktree Capital Management’s high-yield strategy, and the AFL-CIO Housing Investment Trust.

Companies on the watch list receive in-depth monitoring from SFERS investment staff and are subject to termination.

However, the San Francisco system, the board documents show, has been reducing the managers’ allocations while still keeping their investment contracts in place.

As of Sept. 30, the AQR international strategy was down to $612 million after a $100 million reduction in June 2018. 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.

The third investment strategy, the DFA international small cap strategy, was down to $367 million as of Sept. 30, following reductions by SFERS staff of $100 million in March and a second $100 million in June.

The managers all face potential further reductions, according to the staff memo, because the SFERS board in Oct. 2017 approved the reduction in the target allocation to public equities to 31% of the overall $24.4 billion portfolio from 40% (the current weighting is 39%). “Hence, over the next few years, we will be reducing public equity by approximately $2 billion,” the memo said.

It added that the three managers “will be evaluated in the context of the redesigned public equity portfolio.”

The documents show that the AQR international strategy has underperformed its benchmark in the third quarter of 2018 and “over the trailing one- and three-year time periods.”

“Relative to its peer group, AQR’s performance (gross of fees) ranks in the bottom quartile for the one-year time period and in the third quartile for the three- and five-year time periods,” the report said. “Since inception, AQR has outperformed the benchmark by 80 basis points.” The San Francisco pension system hired AQR in August 2006.

In the third quarter of 2018, ending Sept. 30, the AQR strategy had an investment return of 0.1% compared to the MSCI EAFE benchmark of 1.4%. For the one-year period, the AQR strategy had an investment return of -1.5% compared to the MSCI EAFE benchmark of 2.7%. For the three-year period, the AQR strategy had an investment return of 9% compared to the MSCI EAFE benchmark of 9.2%.

“The strategy employs two models seeking to take advantage of three sources of risk: (1) the stock selection model which uses bottom-up analysis to express stock/industry views and (2) the asset allocation model which uses top-down analysis to express country views and currency views,” the San Francisco report stated.

It went on: “a majority of the portfolio’s 3Q underperformance came from the strategy’s global stock selection model, which makes country and currency bets within developed markets, (which)was neutral for the quarter. Over the trailing three years, the negative contribution from the stock selection model and the positive contribution from the asset allocation model have roughly offset each other.”

The report said the William Blair strategy “underperformed its benchmark in the 3Q 2018 and has underperformed over the trailing one- and three- and 10-year time-periods and is in the third quartile for the five-year time periods.”

In the third quarter of 2018 ending Sept. 30, the William Blair strategy had an investment return of -0.1% compared to the SFERS custom international equity benchmark of 1.5%. For the one-year period, the William Blair strategy had an investment return of 2.1% compared to the SFERS custom international equity benchmark of 5.5%. For the three-year period, it had an investment return of 8.9% compared to the SFERS custom international equity benchmark of 9.9%.

“Underperformance relative to the benchmark was primarily driven by negative stock selection,” the report said. “Within the Materials sector, positions in Boliden and Covestro were the biggest detractors. Boliden, a Scandinavian mining company, was hurt by weaker metal prices. Covestro, a chemical spin-off from Bayer, is a global leader in polycarbonate and polyurethane production. The stock dropped despite 2Q results that were ahead of consensus estimates.”

The report went on to say that “M&A Capital Partners, a Japanese company that provides M&A advice to small and medium companies was another significant detractor in the third quarter. The company reported weak 3Q results driven by fewer deals and fewer large transactions.”

One bright spot in the William Blair international portfolio, the report noted, was the money managers holdings in MTU Aero Engines, one of the world’s largest aircraft engine module manufacturers.

“The William Blair team believes that as air traffic increases and capacity improves, the demand for spare parts and maintenance services should also increase,” the report noted.

For DFA, the San Francisco system’s investment staff said the manager had “underperformed its benchmark in the third quarter and over the trailing one- and three-year time periods. Relative to its peer group, DFAs performance (gross of fees) is in the third quartile for the one-year, three-year and five-year time-periods.”

In the third quarter of 2018 ending Sept. 30, the DFA International Small Cap strategy had an investment return of -1.1% compared to its benchmark, MSCI World ex USA Small Cap, of -0.9%. For the one-year period, the DFA International Small Cap strategy had an investment return of 1% compared to its benchmark, MSCI World ex USA Small Cap, of 3.4%. For the three-year period, the DFA international small cap strategy had an investment return of 11.9% compared to its benchmark, MSCI World ex USA Small Cap, of 12.2%.

“DFA applies insights from theoretical and empirical research to identify systematic differences that can be exploited to achieve higher returns,” the report said. “This results in a portfolio that is tilted toward smaller caps versus larger caps, value companies versus growth companies and more profitable companies versus less profitable companies.”

“In the third quarter, DFA’s tilt towards smaller companies hurt absolute performance while their stock selection in the large cap segments hurt relative performance,” the San Francisco report went on.  “Additionally, holdings in the materials sector hurt performance relative to the benchmark.”