Pro Forma Investment Exposure Portfolio

Transcription

1 SAN DIEGO COUNTY EMPLOYEES RETIREMENT ASSOCIATION (SDCERA) Pro Forma Investment Exposure Portfolio February 28, 2015 with a Preliminary Assessment Report Back-Testing and Evaluating Uncompensated Risk Removal Period Back-tested is April 1, March 31, 2015 Based on information gleaned independently from the SDCERA web site by: Financial 2nd Opinions STEWART FRANK, CPA/PFS, AIFA BINGHAM FARMS, MI Phone: sfrank@precisionfiduciary.com URL: J BEN VERNAZZA, CPA/PFS, TEP (UK) emeritus APTOS,CA PHONE: ben@benvcpa.com URL:

2 Table of Contents Testing and Test Results Tests Performed 1 Sources of Our Data 2 Test Results 3 Next Steps Importance of Taking Next Steps 4 What Needs To Be Done 5 Basis for Uncompensated Risk Analysis SDCERA Pro Forma Total Exposure Portfolio 6 Glossary 7-8 Brief Biographies Stewart Frank, CPA/PFS, AIFA 9 J Ben Vernazza, CPA/PFS, TEP (UK) emeritus 9

3 Testing and Test Results TESTS PERFORMED We performed two separate tests to determine the amount of Uncompensated Risk not reduced by diversification in your Total Exposure Pro Forma Portfolio during the trailing 1-year period ended on March 31, Our proprietary testing protocol leverages expertise, software and process to calculate and measure the absolute equivalent number of equally weighted diversification resources,also known as diversification dimensions (KLD), present in a portfolio. Each KLD has the ability to move independently within a portfolio s structure. Because more KLDs equal more diversification and the presence of less Uncompensated Risk, we use what we call dimensionality testing to measure the portfolio s Uncompensated Risk. Your portfolio s calculated number of KLDs is then compared to the number of KLDs present in a "Reasonably developed portfolio of like size with similar allocation between equities and fixed income. See Glossary beginning on page 7-8 for definition of terms and processes used for this assessment. 1

4 SOURCES OF OUR DATA All of the data we used was based on very organized and transparent information available on your web site. The ETFs, Indices, and mutual funds used in our analysis are shown on each asset class on page 6. Some were obtained by reviewing your current derivative to ETF transition plans; some were used because they are actual investments in your portfolio now; and finally we used proxies in some instances from the conversion of the risk parity classification into its exposure by asset class.* *We had difficulty finding in the available data what the category International Credits meant as shown on page 4 of this report. We searched the reports we reviewed on your web site for information on international credits and only came across it once and that was on page 47 of the Salient Portfolio Strategist Report March The significance of this asset category is that it represents almost 15% of your total portfolio exposure. Consequently, on Friday morning, April 3, Vernazza called the offices of Wurts Associates in El Segundo CA and asked to talk with Scott Whalen, but was told he was on vacation. The receptionist was able to patch Vernazza in to speak with Dewitt Miller. He asked him what international credits were and Dewitt said foreign bonds. Vernazza asked him details on the quality and duration of those bonds and he said he was not at his desk and would call back later that day. Vernazza did not receive a return call. We chose a proxy based on very little information other than foreign bonds. 2

5 TEST RESULTS The dimensionality test results for the Total Exposure Portfolio show that it behaves as though it had only 9 individual holdings with the ability to move independently (based upon equally weighted diversification dimensions). The numeric scale and corresponding redorange-yellow-green sectors of the Risk Reduction Meter show, reading left to right, where diversification measurements are for the SDCERA s Investment Portfolio with an asset allocation exposure of $12.3 billion. The results of this Test show that a reduction to the portfolio s Uncompensated Risk brought about by current in- process steps to diversify and reduce derivatives are insufficient, suggesting that an in-depth analysis of risk and diversification be implemented in order to remediate the shortfall and give guidance to the board, the CEO/CIO, the current investment advisers and consultants,and stakeholders. Meter Uncompensated Risk Fiduciary Duty Call to Action Color Reduction Red Grossly Insufficient Breached Remediate ASAP Orange Insufficient Breached Remediate ASAP Yellow Barely Enough Barely Compliant Remediate & Monitor Green Sufficient Compliant Monitor See Glossary beginning on page 7-8 for definition of terms and processes used for this assessment. 3

6 Next Steps IMPORTANCE OF TAKING NEXT STEPS Trustees are prohibited from delegating the management of a trust s diversification strategy to anyone else, including advisors. That means that, if you are a trustee you are totally responsible for a portfolio s diversification strategy, regardless of who made or implemented the diversification decision. Here s why: Failure to diversify on a reasonable basis to reduce uncompensated risk is... a violation of both the [fiduciary] duty of caution and the [fiduciary] duties of care and skill. [Emphasis added], (Source: Commentary to Section 227, Restatement 3rd of Trusts) 4

7 WHAT NEEDS TO BE DONE Following are the steps required to bring and maintain the SDCERA portfolio into compliance with fiduciary diversification standards. 1. Prepare a comprehensive analysis of your portfolio s Risk & Diversification to reduce uncompensated risk to a reasonable, prudent and acceptable level. 2. Identify root causes of the inadequate diversification and remediate their inadequacies. 3. Develop a separate and distinct prudent diversification strategy that will function as a prudent overlay to the return and overall risk strategy. 4. Modify the Investment Policy Statement (IPS) that incorporates the details of the newly developed, prudent diversification strategy and its monitoring guidelines. 5. Work with your CEO/CIO and investment advisers and consultants to assist to make changes that will enhance and further improve the total return while attaining lower and acceptable levels of uncompensated risk. 6. Once the goal is accomplished issue a written certificate addressed to the SDCERA Board, documenting that the diversification strategy implemented in the rebalanced portfolio is prudent and reasonable. 7. Provide periodic monitoring reviews that subject the investment portfolio to a 10-step oversight process and results in issuing a quarterly monitoring report including diversification rebalancing suggestions as necessary. 5

8 Basis For Uncompensated Risk Analysis SDCERA PRO FORMA TOTAL EXPOSURE PORTFOLIO* February 28, 2015 *This portfolio is a pro forma Asset Allocation as of February 28, The actual asset allocation of SDCERA portfolio as of February 28, 2015 has been adjusted by the re-allocation from the exposure of the risk parity/trend following strategies adapted to asset categories (Salient Portfolio Strategist Report March 2015 to the SDCERA Board for Investment Portfolio as of 2/28/15, page 47) and adjusted by the currently in process conversion of derivatives to ETFs (Wurts Associates Asset Allocation Impact Based on Current Derivative Expirations Dates Report March 2015 to the SDCERA Board as of 2/28/15, page 2 ** We had difficulty finding in the available data what the category international Credits shown above meant. We searched the reports we reviewed on your web site for information on international credits and only came across it once and that was on page 4s of the Salient Portfolio Strategist Report March The significance of this asset category is that it represents almost 15% of your total portfolio exposure. Consequently, on Friday morning, April 3, Vernaz a called the offices of Wurts Associates in El Segundo CA and asked to talk with Scott Whalen, but was told he was on vacation. The receptionist was able to patch Vernaz a in to speak with Dewitt Miller. He asked him what international credits were and Dewitt said foreign bonds. Vernazza asked him details on the quality and duration of those bonds and he said he was not at his desk and would call back later that day. Vernazza did not receive a return call. We chose a proxy based on very little information other than foreign bonds. 6

9 GLOSSARY Uncompensated Investment Risk is risk that can be eliminated with diversification and unlike systematic or compensated risk, investors cannot expect added return for assuming more uncompensated risk. Uncompensated risk comes from the inherent risk of investments in industry and sector groupings, individual firms and, in addition, having too many of industries/sectors/firms that are closely correlated. Uncompensated risk represents approximately 2/3 of total risk. Compensated Investment Risk is unavoidable. It is the inherent risk assumed when making any investment. Compensated risk, also known as undiversifiable risk, market risk, or systematic risk because it affects all investments, and is not limited to a particular investment type, security, industry, etc. and investors expect higher returns when assuming more of it. As a result, every participant in the investment market is exposed to it. This compensated risk is both unpredictable and unavoidable. It cannot be changed or diversified away. It changes only when market conditions change. It is considered to be the price of admission paid by everyone who becomes a market participant. Compensated risk is approximately 1/3 of total risk. Note: The source of the estimate of 2/3 of risk attributable to uncompensated risk, and 1/3 of risk attributable to compensated risk comes from Yale Law School Legal Scholarship Repository John H. Langbein, THE UNIFORM PRUDENT INVESTOR ACT AND THE FUTURE OF TRUST INVESTING, , page They cite Brealy at the bottom of page 647 who estimated 69% and 31%. We have rounded it to 2/3 and 1/3. Diversification Dimensions and Resources OR Eigenfactor Dimensionality (KLD) is a companion metric of CC used to quantify the amount of uncompensated risk removed from a portfolio by diversification. KLD measures the number of independent diversification elements or intrinsic dimensions present in a portfolio. Each dimension represents an element which has the ability to act or move independently within a portfolio s structure. The larger the number; the greater the ability of each portfolio dimension to perform independently. Because independent performance is the essence of diversification, when CC is used in combination with KLD, a thorough understanding of uncompensated risk removal is obtained. Concentration Coefficient (CC) provides a measure of a portfolio concentration and is equal to the number of assets if equally weighted. As concentration increases, the number becomes proportionally less. (E.g. a portfolio with 2 assets, equally weighted at 50% each has a CC of 2; if instead, the weighting changed to 75% and 25%, the CC would be s 1.6). CC is an important diversification metric because of the significance constituent weightings have on a portfolio s diversification. CC is used in combination with the KLD metric to quantify uncompensated risk removed from a portfolio by diversification. Higher CC values indicate more uncompensated risk removed through diversification. 7

10 GLOSSARY (CONTINUED) Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers performances. The return of a benchmark is subtracted in order to reflect relative performance. Beta is the measure of an investment s sensitivity to market movements. The beta of the benchmark is So a fund with a 1.10 beta is expected to perform 10% better than its benchmark index in up markets and 10% worse in down markets. Conversely, a beta of.85 indicates that the fund is expected to perform 15% worse than the benchmark index in up markets and 15% better in down markets. R Squared (R 2 ) is the percentage of the portfolio s performance explained by the behavior of the assigned benchmark. R- Squared values range between 0 and 100, where 0 represents the least correlation and 100 represents full correlation. The R-Squared of a portfolio indicates whether the index being used to analyze beta is an appropriate benchmark. If a portfolio's R-Squared value is close to 100, the beta of the investment can be trusted. On the other hand, an R-Squared value that is less than 75 indicates that the beta is not particularly useful because the portfolio is being compared to an inappropriate benchmark. Sharpe Ratio measures the portfolio's excess return over the risk free rate divided by the standard deviation of the excess return. It is a measure of absolute rate of return per one unit of risk. The better an investment's risk adjusted performance has been, the higher its Sharpe ratio will score. A negative Sharpe ratio indicates that a risk-less asset would have performed better than the investment being analyzed. Systemic Risk in finance is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system that can be contained therein without harming the entire system. It refers to the risks imposed by interlinkages and interdependencies where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. Normally systemic risk is not a great factor, but when it is it becomes a tsunami and it overruns all other factors in the market place. 8

11 Stewart Frank, CPA/PFS, AIFA Stewart has been a CPA for 52 years, and for the past 12 years has specialized in the field of Prudent Investor compliance evaluation. During this time, Stewart has provided expert opinions in more than 30 breach of fiduciary cases for both plaintiffs and defendants. He is a recognized expert in fiduciary compliance, having recently contributed content for two handbooks on fiduciary best practices, published by fi360. He also served as a Special Consultant on Fiduciary Matters to the Fiduciary Task Force of the American Institute of CPA s (AICPA) Personal Financial Planning Executive Committee during their technical review of the two handbooks. He is a frequent speaker at meetings of judges, attorneys, CPA s, trustees, RIAs, stockbrokers, Certified Financial Planners (CFP), and not-forprofit board members on the subject of fiduciary compliance. J Ben Vernazza, CPA/PFS,TEP (UK) emeritus Ben has been a CPA for 54 years, and an investment adviser for 39 years. He is founder of The Overseas Oversight Group that has oversight privileges as protector of trusts and companies, as well as starting three other financial advisory organizations. He is also a forensic accountant. He served on five different occasions for four year terms on committees of the American Institute of CPAs including a four year term on the Investment Committee that had oversight over the pension and health plans of the employees of this 350,000 member organization. He was chairman of the AICPA special task force on International Tax Reporting Requirements during Additionally, he served on the asset protection committee of the American Bar Association and as a member of the Probate and Trust Division. Prior to these professional assignments he participated actively in California CPA Society Committees. He sold his investment advisory business in 2012 and started FINANCIAL 2ND OPINIONS in 2014.He received the Private Sector Initiative Commendation from President Ronald Reagan in