San Mateo County Grand Jury • 2007-2008

Issue | Background | Findings | Conclusions | Recommendations | Responses | Attachments San Mateo County Employees'

Published: June 30, 2007 15 pages

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⚠️ Translation Notice: This content has been automatically translated. The original English text is the official version. Translation may contain errors.

⚠️ Este contenido ha sido traducido automáticamente. El texto original en inglés es la versión oficial. La traducción puede contener errores.

Note: Missing finding numbers detected: F10, F11, F12, F13, F14, F15, F16, F17, F18, F19, F20, F21, F22, F23, F24, F25, F26, F27, F28, F29, F30, F31, F32, F33, F34, F35, F36, F37, F38, F39, F40, F41, F42, F43, F44, F45, F46, F47, F48, F49, F50, F51, F52, F53, F54, F55, F56, F57, F58, F59, F60, F61, F62, F63, F64, F65, F66, F67, F68, F69, F70, F71, F72, F73, F74, F75, F76, F77, F78, F79, F80, F81, F82, F83, F84, F85, F86, F87, F88, F89, F90, F91, F92, F93, F94, F95, F96, F97, F98, F99, F100, F101, F102, F103, F104, F105, F106, F107, F108, F109, F110, F111, F112, F113, F114, F115, F116, F117, F118, F119, F120, F121, F122, F123, F124, F125, F126, F127, F128, F129, F130, F131, F132, F133, F134, F135, F136, F137, F138, F139, F140, F141, F142, F143, F144, F145, F146, F147, F148, F149, F150, F151, F152, F153, F154, F155, F156, F157, F158, F159, F160, F161, F162, F163, F164, F165, F166, F167, F168, F169, F170, F171, F172, F173, F174, F175, F176, F177, F178, F179, F180, F181, F182, F183, F184, 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Findings and Recommendations 10 findings

The board acknowledges the historical data demonstrating that the most successful strategy for minimizing risk, while capturing market returns, is a prudently diversified portfolio.

No recommendations for this finding

Therefore, the Retirement Fund should be invested across the spectrum of institutional grade Asset Classes.

No recommendations for this finding

The board acknowledges that the Asset Allocation targets reflect a long- term view of the market.

No recommendations for this finding

The board acknowledges that professional management of the Retirement Fund is expected to add value to the portfolio, by capitalizing on inefficiencies in the markets.

No recommendations for this finding

The board takes responsibility for allocating across asset classes and across styles within asset classes, but does not substitute its judgment for the professional judgment of those managers it retains.

No recommendations for this finding

The board believes that interest, dividends and capital appreciation must be pursued and captured, if the Actuarial Funding Objectives of the Retirement Fund are to be achieved.

No recommendations for this finding

The board is not a market-timer (shifting asset class allocations dramatically over short time spans), because it realizes this strategy is seldom successful and has the potential for dramatic losses and opportunity costs.

No recommendations for this finding

The board views Short-term Cash Equivalents as insignificant contributors to Real Returns in the long run.

No recommendations for this finding

The board is responsible for keeping the lines of communication open and the Investment Plan on target. Many pension funds share SamCERA’s emphasis on diversification and institutional grade asset classes. In addition to the usual statements of goals and philosophy, SamCERA’s Policy includes guidelines and limits in terms of asset allocation and bond ratings. SamCERA specifies further guidelines in the Investment Management Agreement with each fund manager, and it monitors the performance of each fund frequently. In light of the fact that CDOs/CMOs twice removed from subprime mortgages have still received investment grade ratings, SamCERA’s rating requirements may not be sufficiently restrictive. The current rating requirements may depend too much on the prudence and acumen of the rating agencies. Procedures One of SamCERA’s more important procedures is the preparation of a Monthly Portfolio Performance Report (Report) by the Investment & Finance Manager. This Report compares (a) the actual performance of the total Fund with its policy benchmark and the actuarial discount rate, and (b) the actual performance of the twelve component funds that comprise the total Fund with their asset-class benchmarks. The Report also compares returns reported by fund managers with the corresponding returns as calculated by the custodial bank holding the funds; if a significant variance is found, it must be reconciled. With data quality assured, the Report continues to explain the performance of the various funds in terms of their asset holdings vis-à-vis their markets. The Report is as much a review of the efficacy of the fund manager’s decisions as it is a review of financial performance. (See Appendix B for excerpts from the latest Performance Report.) SamCERA consciously avoids micromanagement of its fund managers, but scrutinizes asset selection and performance versus established benchmarks. SamCERA is not hesitant to terminate fund managers for poor performance relative to SamCERA’s established benchmarks. Its standard Investment Management Agreement allows SamCERA to terminate the Agreement on 30 day notice. (See Appendix C for the definition of underperformance.) Terminations of fund managers for underperformance occurred in 1999 and 2004. New managers are chosen via a process that emphasizes objective criteria. Given the level of discretion SamCERA allows its fund managers, the vigilance demonstrated by SamCERA’s procedures is appropriate and necessary. Portfolio Holdings In keeping with its policy of diversification across asset classes and geography, SamCERA’s portfolio is divided among four aggregates11 defined by security type and location (domestic/international). The domestic fixed income aggregate comprises approximately 27 percent of the total portfolio, divided roughly equally among three fund managers, who have anticipated subprime problems and mitigated risk by holding only highly-rated CDO/CMO tranches (AAA and AA). SamCERA’s subprime exposure is less than one percent of its $2.2 billion portfolio. Alternate Sources of Information As noted above, warnings of the potential subprime disaster were raised as early as 2002, by state officials and academics, but these warnings were generally ignored by the mainstream media and federal regulators. Warnings of subprime problems, excessive liquidity and overuse of leverage, were still not in the public eye by 2005, but were being discussed seriously on several Internet “blogs” (web logs). Of course all blogs are not equal, but the best ones are published by respected academics and professionals. Many such blogs are updated daily with analyses of the latest news and data. Blogs also 11 Plus real estate and cash. See Appendix B. 7 incorporate forums (comments sections) where anyone can discuss the current issues. The best blogs attract highly qualified commentators to their forums. Conclusions SamCERA’s Investment Policy implicitly assumes that all the actors in the process which creates an investment grade bond have been prudent and realistic. That assumption was made at a time when lenders took fiduciary responsibility seriously and rating agencies could readily and realistically assess the credit risk of a straightforward bond. Since then, the credit environment has changed for the worse. SamCERA’s Investment Policy relies on diversification across institutional grade asset classes for management of the risk/return tradeoff. Traditionally, investment grade bonds are a mainstay of the fixed income asset class. Subprime-backed securities, e.g. CMOs, can have the appearance of investment grade bonds so that policy guidelines, like SamCERA’s, that include minimum average ratings and absolute minimum ratings, do not necessarily prevent purchases of securities backed by subprime mortgages. Nevertheless, SamCERA’s exposure to subprime mortgages is less than one percent of its portfolio. The Grand Jury concludes that SamCERA’s investment policies and procedures meet the challenges of a traditional investment environment. However, in light of the current subprime market debacle, SamCERA’s management is challenged to be even more forward-looking and to seek guidance from a wider variety of sources. In these days of globalization and rapid financial “innovation,” reliance on traditional sources of regulation and information may be risky. SamCERA’s already good management could be even better if it were more forward-looking. While the monthly performance reviews are thorough and timely, they look at only the recent past. They cannot see the future. Blogs like those mentioned above could prove to be valuable sources of information augmenting more traditional sources. (See Appendix D for a list of sources.)

Related Recommendations (2)

“Broaden their sources of information regarding financial developments and trends, and be prepared to discuss and question the latest financial “innovations” and risk management philosophies with their investment consultant and fund managers.” Board of Retirement Response to Recommendation 1 The recommendation has not yet been implemented, but will be implemented over the course of the next few months as the board and Investment Committee review and discuss appropriate additional sources of information.

“Review their Investment Policy annually, and revise it when there are significant changes in the investment and credit environment.” Board of Retirement Response to Recommendation 2 The recommendation has been implemented. The SamCERA board’s procedure is to review all policies of the board on an annual basis. The Investment Policy will be revised when there are significant changes in the investment and credit environment. Again, the Board of Retirement appreciates the efforts of the Grand Jury and its committee on SamCERA investments. Sincerely, David Bailey Chief Executive Officer

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The section dealing with investment philosophy follows: 1. The board acknowledges the historical data demonstrating that the most successful strategy for minimizing risk, while capturing market returns, is a prudently diversified portfolio.

No recommendations for this finding

Conclusions 1

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SamCERA’s Investment Policy implicitly assumes that all the actors in the process which creates an investment grade bond have been prudent and realistic. That assumption was made at a time when lenders took fiduciary responsibility seriously and rating agencies could readily and realistically assess the credit risk of a straightforward bond. Since then, the credit environment has changed for the worse. SamCERA’s Investment Policy relies on diversification across institutional grade asset classes for management of the risk/return tradeoff. Traditionally, investment grade bonds are a mainstay of the fixed income asset class. Subprime-backed securities, e.g. CMOs, can have the appearance of investment grade bonds so that policy guidelines, like SamCERA’s, that include minimum average ratings and absolute minimum ratings, do not necessarily prevent purchases of securities backed by subprime mortgages. Nevertheless, SamCERA’s exposure to subprime mortgages is less than one percent of its portfolio. The Grand Jury concludes that SamCERA’s investment policies and procedures meet the challenges of a traditional investment environment. However, in light of the current subprime market debacle, SamCERA’s management is challenged to be even more forward-looking and to seek guidance from a wider variety of sources. In these days of globalization and rapid financial “innovation,” reliance on traditional sources of regulation and information may be risky. SamCERA’s already good management could be even better if it were more forward-looking. While the monthly performance reviews are thorough and timely, they look at only the recent past. They cannot see the future. Blogs like those mentioned above could prove to be valuable sources of information augmenting more traditional sources. (See Appendix D for a list of sources.)