The San Francisco Employees’ Retirement System (SFERS) reported investment returns of 7.81% for its 12-month fiscal year ending June 30, beating its expected annual rate of 7.4 % by more than 400 basis points, shows a report by Chief Investment Officer William Coaker Jr.
The report details that the $25.7 billion system’s strong private equity returns of 17.4% helped propel overall returns, despite mixed public equity returns.
At 21%, the San Francisco system has one of the largest allocations to private equity among public pension plans in the US, so the high returns were able to play an outsized role in helping the retirement system with its overall returns. SFERS has around $5 billion invested in private equity.
Public equities, which make up 55.9% of the SFERS portfolio, its largest asset class, saw investment returns of 5.84% in the fiscal year, less than a third of the private equity results. Public equity makes up almost $9 billion of the SFERS portfolio.
Coaker said in a July 10 report presented to the SFERS board that the public equity results would have been even worse if not for the stock market turnaround in the last six months of the fiscal year.
He said returns in the first six months of the fiscal year, from July 1, 2018, through Dec. 31, 2018, were -10.93%, due to concerns over a trade war between the US and China and concern about the impact that tariffs would have on economic growth.
“Since then, those concerns have generally eased such that investors expect a deal between the countries will be reached,” Coaker said. “Further, economic growth has remained solid, thus boosting investor willingness to pay higher prices to own assets whose valuations are more volatile.”
Coaker said it was the second half of the fiscal year that helped public equities move from negative returns and show a positive result for the entire 2018-2019 fiscal year.
“From January to June 2019, our public equity portfolio posted a stunning return of 18.65%,” he said.
SFERS’s small private credit portfolio, which makes up less than 3% of the overall portfolio, was the third-best returning assets class in the portfolio during the latest fiscal year, at 10.68%.
Coaker said the private credit returns were “backed by solid underwriting and our emphasis on unique, niche, and specialist strategies.”
Returns for other asset classes include real assets, which includes real estate, at 8.59%, and fixed income, which saw returns of 7.23%. Real assets and fixed income make up 16.6% and 10.1% of the portfolio, respectively.
The worst-performing asset class was the hedge fund portfolio, which returned 1.7% and makes up 13.6% of the portfolio. Coaker has built the portfolio from scratch over the last several years, arguing it will help the plan during a severe equity downturn. Coaker did not address the hedge fund portfolio in his report.
What will the future bring in terms of future returns? Coaker noted in the report that there could be headwinds.
He noted declines in sovereign bond yields have recently occurred, with the 10-year US Treasury Bond declining sharply to just under 2%. The decline occurred after the 10-year Treasury rose from 2.4% in December 2017 to 3.2% in October 2018, he said.
“The bond market is pricing in expectations of worrisomely low economic growth and ultra-low inflation,” he said. “Meanwhile, the spirits of equity investors about prospects for a resolution of trade continued solid economic growth, have been buoyed, and in the first half of 2019 global stocks soured nearly 19%. Time will tell which of the divergent view proves to be correct.”
While Coaker noted the strong private credit returns for SFERS in this last fiscal year, he also expressed caution about overall trends in the future in the private credit area. He noted that credit conditions in direct lending “have been worrisome for a while now, and recent developments give further reason for caution. The sheer volume of capital chasing investments is substantial, giving borrowers the upper hand in negotiating terms, resulting in fewer covenants and therefore fewer protections for lenders.”
Due to expected low core bond rates, SFERS has attempted to increase its private credit portfolio, which now makes up $740,000 of the system’s $25 billion plus portfolio.
Coaker wants to build the private credit portfolio to 10% of the portfolio over a period of years.
The CIO said rising valuations in private equity and real estate are other concerns that could impact future returns, as well as social unrest in Hong Kong and the fact that the US will soon be running $1 trillion annual deficits.
SFERS estimates it will earn on average a 7.4% return each year on a long-term basis. Its actuarial consultant Cheiron said in a June report that the assumption is reasonable but says the system should also consider lowering its assumption to 7.25%.
The two largest US pension plans—the California Public Employees’ Retirement System and the California State Teachers’ Retirement System—have both lowered their long-term return assumptions to 7%.