MOORLACH UPDATE — Alternative Investments — November 17, 2013

Where should I invest my retirement nest egg now? Great question. The OC Register covers this topic as it reviews the asset allocation of the Orange County Employees Retirement System (OCERS) portfolio in the front-page article below.

First observation: When I reposition my personal investment portfolio, I write a little narrative explaining why I moved a certain amount of funds from one asset class to another. That way I justify the move and it reminds me years later what my logic was at the time.

Second observation: Being a perfect investor is not for the faint of heart. Diversification is a critical defensive strategy that should not be abandoned. Every night there is a television show that provides a sweet little old lady who put all of her funds in a high return investment opportunity, it turned out to be a scam and she lost everything. If she would have just invested a maximum of one-seventh, she would still have the majority of her nest egg.

Final observation: Equities are trading at all-time highs. Putting everything into stock mutual funds now may be too late. If the market corrects, then a ten percent loss of principal could be incurred. Fixed income is also at all-time highs. Putting everything into a bond mutual fund would be a disaster if interest rates rise. Putting everything into actual bonds will assure a return of principal, but the low interest yields provide a hefty opportunity cost (see the lead article in the OC Register Business – The Wall Street Journal Sunday section, titled “It’s Rough Going for Bond Investors . . . and More Ahead.”) And, repositioning into a money market fund, a normally safe place to park assets, will result in a zero rate of return, until interest rates rise.

With these difficult parameters, and the requirement to earn 7.25 percent every year, makes the investment allocation decision process for the OCERS Board a very difficult one. With limited returns on the horizon in the three major investment categories above, equities, fixed income, and cash (which is not a long-term investment and is eschewed by institutional investors), the use of alternative investments provides another option. The strategy, from a five-year perspective, served OCERS well. From a three-year perspective, not so well, and provides an opportunity to second guess. An easy conclusion can be made from the data, and the current status of the marketplace and going forward. Recommending an increase in the current assumed investment return rate of 7.25 percent would be ignoring economic reality and is highly inadvisable.

While fees climbed, county pension earnings lagged

Attempting to overcome lower-than-planned returns from conventional investments, OCERS pumped money into hedge funds and other alternative assets, but efforts may have been counterproductive

By MIKE REICHER

Orange County’s public pension system poured money into hedge funds, private equity and other so-called alternative investments during the past six years, but the returns have proven mediocre despite costing millions in fees.

This year alone, the fund is expecting to pay $54.5 million to alternative-investment managers, according to a budget briefing document obtained by the Orange County Register.

But in financial reports through the first half of the year, the pension system disclosed none of those fees. Officials said they are following standard government reporting practices.

Indeed, the Orange County Employees Retirement System is not alone.

As pension funds nationwide struggle to make up large unfunded liabilities, public officials have shifted billions of dollars to risky investments like hedge funds instead of traditional stocks and bonds. Fund leaders say it’s a way to diversify their portfolios, and they argue for patience with new investments.

But experts say the results, in most cases, have been lackluster earnings for public pension funds and a boon for Wall Street money managers.

“This is a huge feeding frenzy,” said Edward Siedle, whose Florida forensic firm Benchmark Financial Services investigates pension funds. “Never have the fees been as expensive and egregious and opaque … and you can’t justify the performance.”

Orange County’s two main alternative classes – hedge funds, and a mix of commodities, energy and other investments – earned 3.4 percent and 7.8 percent, respectively in 2012, while the S&P 500 earned 13.4 percent. The OCERS real estate fund did better than other alternatives, earning 12.6 percent.

The overall performance of OCERS’ $10.7 billion fundhas lagged behind other public pension systems during the three years ending December 2012. Among 88 of the largest pension systems in the country, OCERS ranked 86, according to a Register analysis of data provided by Pensions & Investments, an industry trade publication.

OCERS reported total returns of 8.1 percent, while other funds, such as the Sacramento, San Bernardino and San Diego county pension systems, notched 9.9 percent and above. Fairfax County, Virginia topped the rankings with earnings of 17 percent.

Siedle, a former Securities and Exchange Commission attorney, estimates that OCERS missed out on more than $125 million of profit during 2012.

Some of those foregone earnings went to the investment managers’ pockets, as hedge funds and private equity firms often take a cut from the returns.

“It’s like running a race with a 10-pound bag tied to your leg,” Siedle said. “You can’t win if your fees are handicapping you.”

Reducing fees is now a focus for new OCERS Chief Investment Officer Girard Miller. On Wednesday, he expects to unveil a plan to pool alternative investments with other California pension systems and then bargain for lower fees.

“We take it very seriously,” Miller said about alternative-investment fees.

Alternative-investment firms command enormous fees compared with those of traditional managers. Typical of the OCERS hedge funds, Bridgewater Associates charges 1.5 percent of the assets it manages, plus 20 percent of profits if it surpasses a certain benchmark.

That is more than 180 times the rate charged by the OCERS basic U.S. stock market fund, a Blackrock index, which charges 0.008 percent of the assets alone.

Just a portion of the total fund investment fees are reported on the OCERS comprehensive annual financial reports. In 2012, for instance, the fees were about $51 million, according to the budget documents, but the CAFR said $32 million.

This happens, in part, because some managers invest in smaller funds, and those smaller funds take a second layer of fees that is hidden in the lower return rate, OCERS officials say.

Pension systems follow Governmental Accounting Standards Board practices, which require all fees to be broken out, unless they are “not readily separable.” A GASB representative said it is up to an agency’s accountant to decide whether such fees should be disclosed, although the fundamental guidance is to show the fees separately.

But opacity is common in the public pension industry, says Siedle, who uncovered tens of millions in obscured fees at the Rhode Island pension fund.

“They have strategically decided to not disclose these fees,” Siedle said.

OCERS Chief Executive Officer Steve Delaney said officials knew that the fees were high but, until Miller was hired in 2012, had not taken the time to quantify the full costs.

Miller, formerly a top executive at Janus Capital Group and Fidelity Investments, said the fees are sometimes justified: “I’m happy to pay for performance when I get it.”

But he acknowledges “there’s a fair criticism” that hedge funds haven’t performed very well recently.

GROWING PIECE OF THE PIE

The notion that high-cost and high-effort investment strategies often flop is not a new one. In a friendly wager, Warren Buffett bet hedge fund manager Protégé Partners $1 million in 2008 that a stock market index, like the S&P 500, would get better returns over 10 years than the hedge fund.

By the beginning of 2013, the stock index had earned 8.7 percent, while Protégé’s hedge funds had earned 0.1 percent.

But members of the OCERS board have shifted more and more of their fund into alternatives. As of September, OCERS had $3.2 billion of its $10.7 billion portfolio in alternatives, which have ballooned from 6 percent of the total fund in 2006 to 30 percent today.

That does not include real estate investments, which most industry observers also consider to be alternatives.

Including real estate, OCERS has 39 percent of its portfolio in alternatives. The national average among state pension funds, by comparison, is 24 percent, according to investment adviser Cliffwater.

“I don’t know how it morphed to that size,” said county Supervisor John Moorlach, who served on the OCERS board until 2006. “What was the logic?”

Moorlach, who identified problems with the Orange County Investment Pool before its collapse triggered the county’s 1994 bankruptcy, said he grows nervous, in general, if such an asset class is more than one-seventh of a portfolio.

Contacted individually to discuss the fund’s performance, eight of the 10 OCERS board members either did not respond or declined a request for an interview. Some cited a board policy that directs media inquiries to a spokesperson. The policy also says board members are supposed to “respect the decisions and policies of the board … even if they may have opposed them.”

Member Frank Eley, who represents general county employees on the board, was one of the few who would comment. Eley said he expects the alternatives to perform better over time.

“I’m not concerned, because I think you have to build a system that lasts for all times,” Eley said. “The only thing that saved us in 2008 was having the most diversified portfolio.”

Miller said the recent OCERS earnings doldrums can be attributed to the diverse asset mix. OCERS isn’t as tied to the stock market as some other funds, so it didn’t fully reap the market gains when public companies rebounded. Also, some of the alternative funds may not hit their full stride for another three to four years, Miller said.

Over the five-year period, when its alternative investments performed better, OCERS finished sixth out of the 88 largest systems.

Either way, a traditional portfolio of 60 percent stocks and 40 percent bonds is antiquated, Miller said. With the Federal Reserve keeping interest rates low, an average long-term bond target return of 5 percent “can’t work mathematically,” he said. Instead, Miller advocates for diversifying risk with alternative investments.

Siedle doesn’t buy the argument.

“How do high-risk investments reduce the risk?” he said. “If I give $100 million to a seasoned poker player in Vegas, am I reducing my risk?”

Contact the writer: mreichering to a budget briefing document obtained by the Orange County Register.

FIVE-YEAR LOOK BACKS

November 13

2008

John Ortiz, the “State Worker” reporter for the Sacramento Bee, addressed the topic of “Voters take aim at civil service pay.” It covers Measure J, but also provides reminders of how difficult the economic situation was at that time in history. In fact, an article in the LA Times that ran the same day was titled “CalPERS takes real estate hit – The value of the huge retirement fund’s investments in housing declines 35% in the year ended June 30.” It was a paper loss of $3.3 billion!

State workers, watch out for another Orange County.

About 75 percent of voters there last week passed a measure that makes county employee and elected official retirement contracts contingent on approval at the ballot box.

The measure’s backers think the vote shows how disgusted the public has become with what many believe are outsized civil service pay and benefits – especially in tough economic times. "We hope that we’re the first in a series of dominoes to fall," said John Moorlach, the accountant-turned-county supervisor who was a driving force behind the measure.

Moorlach and others think that what happened in Orange County could spread. "Orange County could be paving the way for something bigger," said Jon Coupal, president of the Howard Jarvis Taxpayers Association. "You might see a statewide proposal – although the unions would come unglued and probably try to kill it."

The public seems to be in a tough love mood when it comes to civil service workers.

Gov. Arnold Schwarzenegger’s recent proposal to furlough state workers and erase two paid holidays horrified many state workers. Outraged union leaders – most are negotiating new labor deals – said the governor is circumventing the bargaining process.

But people like retired Air Force Master Sgt. Bob Cushman support Schwarzenegger.

"Dire times call for drastic measures," he said. "I have no sympathy for those upset about what amounts to a measly 5 percent cut in pay."

California’s government salaries will cost about $23 billion this year, according to state estimates. That’s roughly 17 percent of the $132 billion the state will spend this year, according to the nonpartisan Legislative Analyst’s Office.

The biggest slice of that is the general fund, the part of the state budget that lawmakers haggle over every year. About $10.5 billion of the money in that pot is committed to 2008-09 pay and benefits. The Legislature and the governor passed the budget assuming the general fund would take in a bit more than $100 billion. It’s going to come up at least $11 billion short.

So here’s how bad things are: If you could junk all the jobs paid from the general fund, it still wouldn’t quite break even.

Cities and counties also face tough choices. The city of Sacramento next year will furlough 900 workers. Sacramento County’s budget features deep service cuts.

Meanwhile, the economy has pushed more private sector workers into unemployment. Mervyns is laying off about 12,000 workers just ahead of the holidays.

"The state’s situation is so grave that it’s hard to imagine a solution that avoids reductions in the 10 percent of the general fund budget dedicated to personnel," said Jason Dickerson of the Legislative Analyst’s Office.

State workers aren’t individually to blame for the California’s mess, but their individual paychecks may soon take a hit. The message from Orange County is clear: The public isn’t sympathetic.

November 14

2003

One of the OC Register’s editorials was titled “Searching for a CEO.” It provided an update on the topic and a kind pat on the back, reflecting my philosophy on how I perceive where my personal talents lie.

Some Orange County observers are scratching their heads at why the Board of Supervisors has had so much difficulty finding a permanent CEO to run county government despite a national search for candidates. The job is influential, the pay is great ($200,000 a year plus cushy benefits) and who can beat the location?

As a recent Register article explained, various politicians and human resources experts blame the county’s revolving door with CEOs, the state’s ongoing budget troubles and the sense that the CEO often winds up serving as a scapegoat for county problems.

So retired Anaheim City Manager Jim Ruth has agreed to stay on an interim basis for another year, while the search continues.

Perhaps the so-called problem really is of the board’s own making. We know of one well qualified candidate who, after being invited to apply for the CEO position by one supervisor, could not even get an interview for the job.

Orange County Treasurer John Moorlach, something of a hero for his role in predicting the Orange County bankruptcy, put his hat in the ring after Supervisor Chris Norby asked that he consider the job.

We don’t know why Mr. Moorlach would want to go from his own elected office to a staff position, but nevertheless he would have been a serious candidate. But only two supervisors wanted an interview.

“I applied because I’m a fix-it guy and I believe the county needs fixing,” Mr. Moorlach told us. “I’m not afraid to take on the problems. I think I have the skill sets to do that.” But after applying, he was told there was no interest in pursuing his application.

We’re not pushing for the county to hire Mr. Moorlach, but do find it ironic that county officials are complaining about the lack of good candidates when they won’t even interview someone with these qualifications, someone who is in their own back yard. We wonder who else has been branded pre-emptively “no interest.”

November 16

2003

The Sunday Commentary section of the OC Register had some advice for the new Governator. The title was “18 Californians worth listening to – These 18 Californians would be good adviser to Gov.-elect Schwarzenegger.” Here’s a Reader’s Digest version of the editorial:

The editorial staff scanned its sources for Californians who value freedom, free markets and individual liberty and at the same time offer depth and insight into subjects that are on the governor’s priority list. (Transition team members were excluded.)

1. Peter Drucker

2. Thomas Sowell

3. Sen. Tom McClintock

4. Former state Controller (and Democrat) Kathleen Connell

5. O.C. Treasurer John Moorlach runs a tight ship and is a standout on state and municipal finance issues.

6. Carl DeMaio

7. O.C. Auditor David Sundstrom

8. Tom Campbell

9. Robert Michaels

10. O.C. attorney Susan Trager

11. O.C. Supervisor Chris Norby

12. Retired teacher Gloria Matta Tuchman

13. Marshall Fritz

14. Robert Poole

15. Mick Pattinson

16. Gil Geis

17. Victor Davis Hanson

18. O.C. Judge Jim Gray

The Transportation Corridor Agencies (TCA) were in the news with a proposed merger of the two toll road agencies. Jonathan Lansner of the OC Register covered one of the nuances in this upcoming dance with “Toll roads’ value still in doubt.” The nuance was the discount rate, which at the time averaged around 8 percent, but rarely dipped below 6 percent. The lower the discount rate, the higher the valuation of the real estate you are appraising. Here’s a Reader’s Digest version of what would be the first stages of an interesting and flawed effort to merge.

Last week, in a formal respons, the appraiser – Don McDougall of Marshall & Stevens – wrote to the TCA that his $4.9 billion valuation of the TCA roads should be considered conservative.

What’s largely in play here is an arcane and subjective financial concept, the discount rate. It’s a business measure that helps weigh prevailing interest rates plus financial risks in a project.

This debate isn’t an esoteric discussion about valuation technique – it’s critical for plans to merge the TCA’s two roads. Regulations require that the two roads be valued in excess of their debts – a hefty $3.8 billion combined – as one key step in a controversial merger that would bail out the financially ailing San Joaquin Hills (73) Toll Road.

In his appraisal released in October, McDougall came up with his valuation of the two roads using a 5.9 percent discount rate. By contrast, a 13 percent to 14 percent discount rate was used by OCTA late last year in valuing the 91 lanes it bought from private investors for $207 million.

John Moorlach, the county’s treasurer, thinks the TCA’s toll-road valuation looks pretty high.

“Maybe the supervisors should hire their own appraiser, too,” he said, referring to county government that has its own financial adviser review the TCA’s proposal.

November 17

1998

The local news for the city of Perris was provided by The Press-Enterprise in the Perris City News. It had a headline that seems to be a common occurrence now, with “Perris warned it could go bankrupt – Auditors warn that the city has borrowed $3.3 million from other municipal funds and has little idea how much is owed to which.” This past week, the city of Desert Hot Springs has made it to the headlines on the fiscal emergency topic. This article, written by Raul Hernandez, gives a perspective on the topic fifteen years ago.

A new audit concludes that Perris is heading for bankruptcy if the city doesn’t begin paying back $3.3 million it borrowed from other municipal funds to stay in business.

Making matters worse, the audit says, is that city officials don’t seem to have a grasp on what is owed to each fund or what the consequences would be if the funds are not repaid.

“This raises substantial doubt about the city’s ability to continue as a going concern,” says the audit, by Moreland & Associates of Newport Beach.

The city’s monetary problems can be traced to 1994, when the deficit was $2.2 million, said Interim Finance Director Terry Shea. The city began raiding various accounts, such as its sewer and water and redevelopment funds, to meet its current cash needs. It now owes $3.3 million to these and other accounts.

“We borrowed money from other funds. There is a whole list. I don’t know how it breaks down,” Shea said. “In its present course, the city will eventually go bankrupt if they spend more than they take. Hopefully, we will stem that tide.”

To do so, city officials have formed a finance advisory committee that includes Mayor Al Landers, Councilman Ascencion “Sam” Torres, interim City Manager Ron Molendyk, Shea and perhaps others. The committee is expected to meet before the end of the year.

If Perris makes the right moves, Shea said, it could wipe out its debt in three to five years.

Orange County Treasurer and Tax Collector John Moorlach, who warned Orange County officials that they were heading into bankruptcy several years ago, said Perris officials must look at four basic elements: what can be cut, what revenues can be raised, what assets can be sold and how the debt can be restructured.

Moorlach said that the warning offered by the auditor is unusual and that something should be done soon.

Shea said more additional tax revenue will be coming into city coffers as the economy improves, but not enough to pay off the debt.

Torres said the city must consider cutting its contract services, which cost more than $6 million a year, and perhaps selling its water utility to raise money.

“The only other alternative is that you raise taxes,” he said.

Financial challenges are nothing new to Perris.

Earlier this decade, the city faced bankruptcy and laid off 17 employees from a work force of 60. Those who stayed took 12 percent pay cuts. City services were cut back, and the city’s police force was dismantled in favor of contracting with the Riverside County Sheriff’s Department.

Officials blamed the problem on a lingering recession and the downgrading of March Air Force Base into a reserve installation.

Landers also blamed incompetence. “There’s been a lot of mismanagement,” he said.

Moorlach, however, said city officials must veer away from name-calling and show leadership in tackling the debt.

“The past is the past. Mistakes are made. You can’t be looking at life through the rear-view mirror,” he said. “Show some leadership or step aside and let someone else do it.”

2008

Norberto Santana, Jr., of the OC Register, provided the reaction to a decision that newly-appointed Sheriff Hutchens had made. She was responding to the evidence that was being revealed in her predecessor’s criminal case, where concealed weapons permits were granted as a result of political contributions. She overreacted and it brought on a large contingent of CCW permit holders that did not want to lose those permits. The piece, “Sheriff in for a fight – Some county supervisors are angered over Hutchens’ revocation of gun permits and will debate the issue,” set up the debate that would occur the next day during the Board of Supervisors’ meeting. I tried my best, behind the scenes to persuade Sheriff Hutchens to rethink her approach to the matter. This is about all a Supervisor can do, as independently elected County officials are just that, independent. Here is a selected segment of the article:

Last month, Hutchens began a systematic review of the 1,100 concealed weapons permits granted under Carona and started revoking current permits.

That has triggered an avalanche of emails and phone calls to supervisors and they aren’t happy.

“I don’t like her views at all,” said Supervisor Janet Nguyen about Hutchens revocation of so-called carry concealed weapons permits. And Nguyen is angry that Hutchens has moved to revoke permits without bringing in the supervisors or stakeholders on developing a new standard.

“She’s becoming like Carona,” Nguyen said. “She needs to understand she needs to work with us.”

County Supervisor Chris Norby is prepared to present a resolution at the board on Tuesday, where hundreds are rumored to show up, calling on Hutchens to halt her revocation of permits.

And while that effort had drawn fire from Supervisors’ Chairman John Moorlach – who argues that the supervisors are prevented by law from interfering in the process of granting ccw permits – even he is uneasy with Hutchens sweeping revisions.

“I’m the chairman of the board,” Moorlach said. “So I want to be supportive of my department heads even when I disagree with them. That being said, I believe Sheriff Hutchens could have handled this a lot differently. She could have addressed it in a different way.”

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