Fidelity International Small-Cap Strategy Terminated by SFERS

The investment made up 6.5% of the system’s approximate $3.5 billion small cap strategy.

The board of the $24 billion San Francisco Employees’ Retirement System has approved terminating money manager Fidelity Institutional Asset Management’s Select International small cap equity strategy due to underperformance relative to its benchmark and other money managers.

A video stream of the system’s Jan. 9 meeting shows the board unanimously terminated the strategy. The system’s investment in the strategy totaled $174.5 million as of Dec. 31, but made up 6.5% of the approximate $3.5 billion small cap strategy, SFERS documents show.

Fidelity Institutional Asset Management is part of the much larger Fidelity Management & Research, commonly known as Fidelity Investments. It is one of the world’s largest assets managers with around $2.5 trillion in assets.

A SFERS memo from its investment staff gives a rare, inside view of issues inside Fidelity concerning the investment strategy.

The Jan. 9 memo notes that the San Francisco pension system has not been the only institutional investor pulling money from the strategy, as it saw $1.9 billion in net outflows from January 2016 through Sept. 30, 2018.

SFERS first put $240 million in the strategy in August 2011, which peaked at $350 million in Sept 2016. The memo said since then, SFERS has redeemed a total of $200 million from the strategy. It placed the strategy on its under-review list in the fourth quarter of 2017.

The memo said in each of the past three years, the strategy has underperformed its benchmark while also ranking in the second half of a universal of other manager strategies.

“The strategies’ performance has been pretty pedestrian,” SFERS Chief Investment Officer William Coaker Jr. told the board. “We are looking to upgrade the portfolio and increase our excess returns,” he said.

SFERS returns data show the Fidelity strategy saw returns of -10% for the one-year period ending Nov. 30 compared to the MSCI World ex USA small cap benchmark’s return of -9.9%. For the three-year period, the strategy returned 4.8% compared to the benchmark’s return of 6.2% and for the five-year period, the strategy returned 3.7% compared to the benchmark’s 4.1%.

The SFERS memo notes that a 2010 report by its then-investment consultant, Angeles Investment Advisors, recommended that Fidelity be hired due to then-strong performance in the strategy, but also expressed caution if there were portfolio management changes. It said the memo noted the importance of portfolio manager Rob Feldman as the “key decision-maker on the portfolio” and that “his departure from the team for any reason would be a cause for immediate concern.”

The memo says that SFERS was notified by Fidelity in the first quarter of 2018 that Feldman would be stepping back from his role. It says that Feldman is listed at the strategy as a co-portfolio manager, but that he is on long-term leave because of health issues. In an email to CIO on Tuesday, Fidelity wrote, “Rob Feldman is facing health issues, but remains actively involved on the strategies as co-portfolio manager.”

SFERS noted in the memo that Feldman was replaced by Shah Badkoubei as lead portfolio manager in March 2018. Badkoubei had been associate portfolio manager since 2013.

Fidelity also appears to have been the victim of SFERS’s move to smaller money managers.

The SFERS memo said that Fidelity Institutional Asset Management, the Fidelity group that ran the SFERS strategy, was quite large.

“The public equities portfolio is shifting towards smaller, more nimble firms with a singular investment focus,” it said. “Staff believes that FIAM does not meet these criteria given their sizeable assets ($164 billion as of Sept.30, 2018) and the number of strategies (80) that they manage.”

The memo said SFERS is looking to hire concentrated, high-conviction strategies and notes the largeness of the Fidelity strategy, with approximately 200 positions.

Last month, the SFERS board approved a $500 million allocation to an international stock strategy run by Select Equity Group as part of a restructuring of its public equity portfolio. Select is a smaller manager that runs high-conviction, concentrated strategies. Coaker told the board at the Jan. 9 meeting that the hiring of Select was an example of “upgrading” the SFERS equity portfolio.

Three other international equity strategies were also added to the watch list last month by SFERS: the William Blair international growth strategy, the DFA international small cap strategy, and the AQR international strategy—all of which have had performance problems.

Public equities make up $8 billion of SFERS’s $24 billion portfolio, but Coaker expects to reduce the size of the equity portfolio by around $2 billion in the next several years as part of the restructuring that is allocating more assets to private markets.

William Blair, DFA, and AQR have all seen the amount of money they manage for SFERS trimmed and Coaker has said that additional cuts could occur without improved performance.

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