From the August 01, 2010 issue of Futures Magazine • Subscribe!

Lee Partridge: A diversified approach to diversification

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One year ago, Lee Partridge left his position as deputy chief investment officer of the Teacher Retirement System of Texas (TRS) to form Integrity Capital, a consultancy dedicated to managing institutional investment portfolios. A month later, Integrity and Partridge signed on as portfolio strategists for the San Diego County Employees Retirement Association.

Partridge helped build TRS into one of the most successful and innovative public pension plans, overhauling the plan’s asset allocation. Futures talked to Partridge about his trading philosophy and approach to asset allocation.

Futures Magazine: Lee, you described yourself as a bond trader. Give us a little background on how you became involved in trading and how your career evolved.

Lee Partridge: When I finished my [MBA from Rice University], I ended up working for a wholesale bank in Overland, Kansas that served credit unions around the country and that wholesale bank had a trading and sales operation that I was involved in so I worked with them creating structured products as well as trading asset backed and other structured finance securities. I carried that over into the insurance world, then started trading rates for the Texas Teachers [Retirement Fund] in 2001. [I covered] everything from structured products and esoteric finance to clean sovereign rate trading and later took over all of the fixed income operations at Texas Teachers and that evolved into more tactical asset allocation and more of a global view of the portfolio.

FM: The Texas Teachers Retirement Fund has a reputation of being innovative. Did that shape your investment philosophy?

LP: Well, I helped shape that. When I came in to run fixed income, one of the things that I emphasized is not taking the low breadth bets like calling the direction of interest rates or allocating to credit or away from credit making those big sector decisions. Instead we would try and take relative value out of each market. All relative value, lots of different positions in the portfolio. In 2007, Britt Harris came in as the new CIO and he asked me to launch a new team that did strategic asset allocation: tactical asset allocation largely using futures and other liquid instruments, risk management and portfolio construction for the new fund. I took that effort on in 2007 and worked with Britt to redefine the asset allocation for the fund and that is when we went to a much higher allocation to alternatives. We looked at the portfolio in the same three categories that I am looking at this portfolio: equity or growth oriented assets, stable assets that are really bond like and real return assets that help mitigate inflation risks. Those are the three elements of the portfolio that we thought drove the returns of all of the underlying asset classes.

FM: I know you are much more involved in asset allocation and portfolio creation than simply trading today, but give us your philosophy as a trader. What lessons did you learn as a trader that still serves you in your current work?

LP: Don’t put all your eggs in one basket. Even if you really have high conviction on a particular idea, you still want to control how much risk you carry in that one idea and always have an exit in case it goes against you. The best traders are probably only dealing with a 60% probability of being right on any given trade so you don’t want to lose all of your capital if things are in the 40% criteria. And be aware that there are fat tails. It is very easy to get into trades where you make a little, make a little, make a little and then you lose a lot. I would definitely put credit in that category and I would put short options positions in that same category. Some of those are reasonable strategies but those do not evidence skill because most of the time they are making money but when they lose they lose all of the money that you made.

FM: You noted that most pension plans are underfunded and face political risk. How serious is the problem?

LP: It is difficult to quantify the exact dimensions of this problem within the United States but the one thing that people have observed is the sheer size of these plans compared to the output of local or state economies. [They] have become a very important part of those economies. What is critical is to manage the downside risk because if we get into a situation where across the table, pension plans lose 30% or underperform their targeted return by 30%, that puts a huge strain on the taxing base of these state and local economies. The important thing to think about is how much downside risk these plans [can] bare and that is what we are really focused on; not to have a devastating drawdown event at the plan.

Most public pension plans are underfunded right now. Most are 80% funded as they estimate their actuarial value but as losses come in from 2008 and that starts to roll into the averages the picture gets worse and worse even if we stay at current market levels. A lot of the cause for that was the heavy reliance on equities as an asset class to achieve intended income returns. That is why I felt that most public pension plans are under diversified. In 2008, the lack of diversification — really this whole decade — coupled with a high return objective has really caused the underfunding problem. If they had been adequately diversified they would not be underfunded today.

FM: Can you list four or five of the most important steps pension fund managers should take to improve the long-term outlook of pension plans?

LP: Diversify your investment portfolio, focus on downside risk, set attainable goals, resource the investment operation sufficiently and the last one is near and dear to my heart, consider cooperative structures to achieve these objectives so share resources with other plans, share due diligence, do joint ventures. There are a lot of opportunities to cooperate across public pension plans.

FM: Would a plan actually share an allocation with another plan if the minimum investment level was too high?

LP: That is a great example. If they didn’t have the required minimum, they could piggyback on larger order flow and get the diversification that would come from a larger portfolio without necessarily paying the full fees of a fund of fund manager that they would have access to.

FM: Everyone involved in investing will say diversification is very important, but how they define diversification can vary widely. How do you define it?

LP: Diversification really doesn’t come from the number of positions you have in the portfolio or the number of managers that you have. It really goes back to how many different return streams you have that are clustered together and how many of them are fundamentally different than one another. So we look at all of our traditional asset classes: our hedge fund assets classes and our private market asset classes side by side. We don’t think of alternatives as being one generic bucket and we don’t think of hedge funds being one generic bucket. We look at each distinct return stream and try and figure out how much volatility there is associated with that return stream and what fundamentally drives positive or negative returns in that return stream. And what we found is generally the three key drivers are the rate of growth in the global economy, the rate of inflation in the global economy and the level of investor risk aversion or appetite. Those three things seem to drive most of the asset classes or styles that we can identify and what we want to do is diversify within that whole queue of inflation, growth and investor sentiment or risk aversion.

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