Amid recent media coverage, it would be easy to think Albertans’ public retirement investments are at risk. Let me reassure you, they are not.I read this letter last week and here are my quick takeaways:
To be direct, the thousands of Albertans who are working courageously on the front lines in health care, law enforcement and other public service roles during this global health crisis, many of whom are members of the pension funds AIMCo serves, have enough to worry about. They do not have to worry about the investments that support their retirement security.
As CEO of AIMCo, I am accountable for the performance of our organization. I am also responsible for setting the record straight.
Recently, the media has reported on a volatility-related investment strategy we manage that resulted in a significant loss. This occurred because the losses that quickly accrued as market volatility dramatically increased and remained elevated were not able to be offset by the gains that would normally be realized as volatility returned to more typical levels. Markets behaved in a manner never- before-seen and the result was a very unfortunate loss.
In addition, media reporting has dramatically overstated the extent of the losses, by 43% on the low- end and 100% on the high-end. Realized and unrealized losses combined to date are approximately $2.1 billion of the $118.8 billion of assets we manage on behalf of our clients. While that figure will likely change, we have actively taken a number of steps to limit the eventual loss. Actual losses will not be finalized until the strategy is completely wound down, which should occur by mid-June.
Anytime you are counting in the billions, it is a big number worthy of attention, and I certainly would never want to experience such an outcome from a strategy. When record-setting market movements occur — recall the TSX suffered its biggest one-day plunge in eight decades — new lessons will inevitably emerge, as they clearly will here at AIMCo. Others across the investment community will be doing the same, I am sure, as the final impact of this global recession is measured.
I believe that one lesson that will be reaffirmed by us all is the power of diversification over the long run. Inherent in this principle of diversification is the notion that some asset classes or strategies will perform negatively under certain circumstances. AIMCo has had longstanding success in building well-diversified portfolios, ones that deliver strong investment returns while managing total risk. Our track record of success in doing this is clear, even if the recent performance of this strategy is not acceptable.
As an independent investment manager, AIMCo takes full responsibility for the investment losses incurred by this strategy. Over the past few weeks, we have focused on implementing measures to minimize the potential losses from this strategy and across our entire portfolio, while honouring our commitment that our clients remain fully informed of our results.
Let me be clear, the performance of this investment is wholly unsatisfactory and AIMCo’s Board and Management share the frustration and disappointment of our clients, their beneficiaries, and all Albertans.
We are committed to learning important lessons from this experience. AIMCo’s Board of Directors has begun a thorough review of this situation. They are using both the strength of AIMCo’s internal audit capabilities, as well as outside, third-party experts.
We would like Albertans to know that every day, I, and the team I lead, go to work to help our clients secure and grow the pensions, endowments and government funds they run. It is both a responsibility and a trust. We will continue to keep our clients and stakeholders informed in a timely manner. We welcome their ongoing input as well.
Please know I am fully focused on one thing: making any and all changes to ensure AIMCo is stronger and that we avoid a repeat of this outcome, regardless of market turmoil.
Take care and stay safe.
- First, why is it AIMCo's CEO and not the Chair of the Board, J. Richard Bird, responding publicly to this volatility blowup? If I was the chair of AIMCo's Board, I would have immediately hired a third party firm to investigate the entire volatility strategy to understand the losses, made that public in a short statement and set a three month time frame to publish an in-depth report which I'd also make public. Governance lapse 101: You don't have the CEO and senior managers responsible for billions in losses come out with a public statement and investigate their own losses.
- Having said this, Kevin Uebelein was probably pressured by AIMCo's Board to make some sort of public statement and he wanted to set the record straight. He did, stating that that realized an unrealized losses were in the vicinity of $2.1 billion (not $3-4 billion) as they let the profitable leg of the strategy recoup some (not all) of the losses.
- Uebelein takes full responsibility for the "wholly unsatisfactory" performance of this investment but also reminds people they are investing for the long run and diversifying across public and private markets.
- That last diversification argument is a bit of cop-out, however, standard Canadian pension corporate speak after losing billions. Notice he made no mention of how they didn't size the potential losses this volatility strategy appropriately or the role of risk management in the implementation and follow-up of this strategy. The reason? He probably doesn't want to publicly state anything that can incriminate him and his senior managers which is why I come back to the governance and the Board's responsibility to hire an independent third party to conduct a thorough, independent review of what went wrong in this volatility strategy. If not the Board, then Alberta's Treasury Board or Ministry of Finance should conduct a full, independent review.
- Kevin Uebelein is right about one thing, despite the massive losses in this volatility strategy, AIMCo's members do not have to worry about the investments that support their retirement security. They screwed up huge in this volatility strategy but it's not right to question all their other investments and the diversified asset mix which is fine and in line with industry best practices.
AIMCo obviously didn't and that's why experts came out stating'amateurish trades' blew up its volatility program:
The Alberta Investment Management Corp. — which manages pension assets, sovereign wealth, and other public money — lost billions by protecting Wall Street banks against an extreme stock market crash, experts said.Again, it's up to AIMCo's Board or Alberta's Treasury Board or Ministry of Finance to conduct a thorough, independent review of what when wrong with this volatility strategy.
AIMCo killed its volatility-trading program in reaction to the blow-out, which has cost Albertans about C$2.1 billion, the organization’s CEO said in Thursday letter.
“While that figure will likely change, we have actively taken a number of steps to limit the eventual loss,” Kevin Uebelein wrote to stakeholders. “Actual losses will not be finalized until the strategy is completely wound down, which should occur by mid-June.”
AIMCo staffers built and ran the now-defunct volatility program, which involved highly complex trades and esoteric derivatives prone to misuse, experts said.
In one common trade — of so-called capped-uncapped variance swaps — Wall Street banks paid the Alberta fund to cover unlimited losses in the event of an extreme stock market crash.
Many traders believed that they were effectively getting free money. Banks were paying to get risk off their books in order to pass stress tests regulators imposed after the last financial crisis. But, the thinking went, the insurance would never actually pay out, because such a dramatic crash had never happened.
In trader-speak, these kinds of deals are called “selling the small puts,” and are often described as picking up pennies in front of a bulldozer.
“The capped-uncapped strategy is amateurish,” said Gontran de Quillacq, a vol market veteran who consults for institutions and attorneys when funds blow up. “Selling the small puts is a beginner’s mistake,” according to de Quillacq. “Anybody with experience in options and volatility trading knows that those ‘century-rare’ events happen every few years — much more frequently than the simpler math would tell you. It’s a guarantee. How often should you play Russian roulette? How about with three bullets?”
“I am always shocked when I see supposedly ‘institutional funds’ or money managers getting into those strategies,” he added.
Without knowing the specifics of AIMCo’s positions, he pointed out that “Alberta is a qualified investor. As such, it is expected to know and understand what it is doing. It’s not the job of the sales to know AIMCo’s strategy, which they can’t know anyway. Alberta took a risk that was too large.”
Most American institutions avoid the sector or pay outside firms to trade it for them, with varying results. However, even the leaders of U.S. public funds readily hold up their Canadian counterparts as role models.
The Canada Pension Plan Investment Board and Ontario Teachers’ Pension Plan are among the world’s top institutional investors. And both are well-known and “aggressive” volatility players.
Experts and data put AIMCo on a lower tier of sophistication. The organization may not have understood the risks it was taking. Or AIMCo leaders buckled under pressure mid-crash and killed a thoughtful — if risky — program.
“If you didn’t have the stomach and weren’t prepared for a 40 percent drawdown, you shouldn’t have been involved” in volatility markets, said Taylor Lukof of ABR Dynamic Funds, a successful trading firm, about institutions generally. “If you haven’t properly managed expectations with your stakeholders, you may be forced into suboptimal decisions when vol is really, really high.”
Institutional Investor broke the story of AIMCo’s blunder last week, estimating losses at $3 billion. Other media reports pegged them at $4 billion, which Uebelein pushed back against.
The trading debacle has inflamed Albertans, who already face a woeful economy and mass layoffs as Canadian oil prices hit historic lows.
Uebelein promised that a “thorough review of this situation” has begun, “using both the strength of AIMCo’s internal audit capabilities, as well as outside, third-party experts.” AIMCo initially blamed the stock market, but also expressed contrition.
“Markets behaved in a manner never before-seen and the result was a very unfortunate loss,” Uebelein wrote in the letter. “Let me be clear, the performance of this investment is wholly unsatisfactory and AIMCo’s board and management share the frustration and disappointment of our clients, their beneficiaries, and all Albertans.”
Anything else would make a mockery of AIMCo's governance. If you gave me $120 billion to manage and I lost $2 billion on a vol strategy that blew up, would you trust me to conduct a full, independent review of what went wrong? Of course not, that's just plain silly and fraught with conflicts of interest.
Where are AIMCo's board members? These are highly qualified and experienced people who are in charge of supervising this fund. They need to step out of the shadows and speak up on what will be done to ensure full transparency and accountability concerning this volatility blowup.
If I was sitting on AIMCo's Board, I'd reach out to experts like David Long at Alignvest, Jim Keohane and others to really understand what went wrong.
Recall, David Long shared important insights with my readers on AIMCo's volatility blowup. I shared more insights from another expert in my follow-up comment on how AIMCo will conduct a full review.
And this weekend, yet another expert, Brett Friedman, shared this with me:
Assuming media reports that AIMCo sold variance options were indeed correct:I asked Brett about his qualifications and this is what he shared:
1)In general, I would call into question why AIMCo was pursuing such short vol/gamma trades to begin with. As a hedge for the overall portfolio, or as a means to add incremental alpha, the strategy is questionable. In addition, the management of the strategy and its proper place and size in the portfolio should be questioned. Hedging a short options position, either with the portfolio itself or separately, is a very tricky matter that has confounded many professional options traders. Devising a hedge is one thing but executing it in extremely volatile markets is another and requires a completely different level of execution and operational skills. The difficulty in that step is usually vastly underestimated.
2)In AIMCo’s defense, they were probably under considerable external pressure to show better returns. Also, basing position sizes and strategies on a scenario that vol would jump radically as a result of a global pandemic wasn't realistic and would probably have forced the fund to be flat or to hold positions that would never yield their return objectives. In the real world of risk management, there are always doomsday scenarios -- the question is how probable they are and the cost of avoiding them vs expected return. Wearing a hard hat outside at all times to avoid a meteor strike isn't good risk management.
3) Most likely, whatever product or package of products they used to sell volatility was dreamed up by GS, JPM, MS, etc.: the usual suspects. Beware of Wall Street derivative salesmen bearing gifts, especially those promising “incremental alpha”!
4) This probably wasn’t the first time they sold such a product. Up until this incident, the strategy had probably worked out well over the years (i.e., since the last financial crisis) and was a quiet way of adding bps to return; incremental alpha, as it were.
5) Since undoubtedly it was very under or overpriced at execution (depending on the exact product), AIMCo's initial edge was gone. Originally, AIMCo probably considered hedging the instrument itself but then decided that it wasn't worth the trouble because the doom and gloom scenario was just too farfetched, and it had worked out numerous times in the past. In this case, however, and by the time the trade was exploding, it was almost impossible to hedge due to, ironically enough, market volatility. They found themselves in the classic naked short option problem that eventually confronts (and confounds) all professional options traders.
6) In that scenario, and adding to the problem, option prices themselves become very difficult to predict. It is instructive to look at option pricing behavior in energy and power as their volatility regularly goes over 100%. In hyper volatile markets, all deltas regardless of strike converge to 0.5 and become very difficult to predict. Consequently, managing a delta hedge under such conditions becomes almost impossible -- definitely not for the faint of heart or those inexperienced in such matters.
7) After vol spiked, they were caught and probably didn't want to cut because the loss was too big or they couldn't cut at "reasonable" prices. In other words, at that point they were praying that it would come back. It's usually at this point that losses go into hyperspace.If they couldn’t hedge the instrument in the market using conventional instruments, at that point they would have been forced to try to cut it with the counterparty they transacted with originally, e.g., GS, etc. Good luck.
8) One very common procedure in trading disasters such as this and usually pushed by the Big 4 is to separate the trade from the portfolio, rename it, and appoint someone whose sole job it is to manage the situation. Many banks did this in 2008 due to all the mortgage derivatives on their books. As someone who has managed just such a book, I can tell you that this strategy extends the pain, consumes management attention, and doesn’t really do all that much other than present the appearance of doing something.
I am a Partner at Winhall Risk Analytics (www.winhallriskanalytics). Basically, professors, CFAs, and market practitioners that advise on trading strategy, models, and valuation. We have an endless supply of PhD candidates from NYU that provide support (they're cheap, smart, and very motivated!). We regularly team up with other consultancies, including Ken Akoundi's Cordatius, if the client wants "size" or a big name.There you go, another expert I'd contact if I was sitting on AIMCo's Board.
As a first step, and based on my experience with similar incidents, I suspect that AIMCo's Board is looking for outside advisors to help out on an audit -- the who, what, when, where, and why of the situation with some recommendations as well. I suspect the Board will also be looking for recommendations on changes (strategy, management, risk management metrics, procedures) so this doesn't happen again. Since I've done this type of work before, I would love to help out on this. Finally, we could also help AIMCO on the strategy itself, with its disposal, or on their overall strategy going forward and the proper role of derivatives.
What else? If I was siting on AIMCo's Board, while waiting for results of an internal audit, I'd seriously consider farming out this volatility strategy to an outside firm which has successfully managed such a strategy for years.
In particular, I'd talk to the folks at Trans-Canada Capital (TCC) who can easily manage this strategy on behalf of AIMCo's clients. Not only are they pension experts now helping other corporate and public pensions, they are highly professional, highly ethical and highly qualified to manage such a complex strategy on behalf of AIMCo's clients (at a very reasonable cost).
I'm dead serious about this recommendation, AIMCo has been put through the wringer because of this massive volatility blowup and its Board needs to send the right message as soon as possible.
Notice, I am NOT recommending that AIMCo stops engaging in this volatility strategy altogether because this wouldn't be in the best interest of AIMCo's members over the long run. If you have it set up right and managed properly, this is a highly profitable strategy over the long run.
Lastly, following my last comment on how AIMCo will conduct a full review, Denes Nemeth and I had a quick chat on the phone. He told me Kevin Uebelein responded publicly and that the Progress Alberta report was sketchy, biased and misinformed.
He reiterated that AIMCo is completely independent from the Alberta Government and that these investments in oil and gas junior companies were made when the previous (NDP) government was in power (and pushing a pro-Alberta stance).
I did find it odd that Progress Alberta was making outlandish statements and if it ever came out AIMCo was supporting any government in any way, it would backfire and explode on all fronts.
Perhaps like CPPIB, any time a politician in Alberta contacts AIMCo, it should be made public regardless of which party they represent (politicians are doing a fine job screwing up the Canadian economy, they need to stay the hell away from our public pensions!).
Denes also told me it most likely wasn't AIMCo's largest clients, the Local Authorities Pension Plan (LAPP), which leaked anything to the media concerning losses on the volatility strategy.
Alright, I've shared a lot on AIMCo's volatility blowup in recent weeks and want to take a breather from this topic. I am on record with my views and if you have anything to add or just want to criticize me, feel free to email me at LKolivakis@gmail.com.
I stand by everything I write on my blog but God knows I don't hold a monopoly on wisdom when it comes to pensions and investments. I try to be as fair and balanced as possible but yes, I have my opinions and I'm not shy about sharing them.
Any way you slice it, the folks at AIMCo screwed up huge on this volatility strategy. They know it, their Board and clients know it, and now the world knows it. It's time to move on and get a full, independent review of what went wrong with this infamous volatility strategy.
Below, Kevin Uebelein, chief executive officer at Alberta Investment Management Corporation, talks about how one of Canada's largest pension funds is managing the shockwaves from COVID-19. He says with the oil crash, energy companies need to keep being competitive so that the forward momentum doesn't stop. (this interview occured prior to media stories on vol blowup)
And CNBC's Scott Wapner discusses the US markets with Bank of America's Keith Banks. Good discussion, listen to his insights and why he sees more volatility ahead.
Update: After reading this comment, Denes Nemeth, AIMCo's Director of Corporate Communication, sent me this:
I feel it is worth pointing out that in our message from Kevin, we very clearly stated that the Board has initiated an independent assessment of this situation that will leverage both our internal audit capabilities and external third-party expertise:I thank Denes and think it is worth clarifying here. However, it doesn't come out clearly in the statement and in my opinion, it absolutely should have been the Board, not the CEO, which came out with this statement and set a clear timeline as to when this independent review will be completed.We are committed to learning important lessons from this experience. AIMCo’s Board of Directors has begun a thorough review of this situation. They are using both the strength of AIMCo’s internal audit capabilities, as well as outside, third-party experts.We may disagree as to whether this is a matter that the Board should be speaking to publicly or one that AIMCo’s executives can properly address, but several times you question the independence of the Board’s assessment, which is an outright falsehood. This assertion is peppered through your commentary, so I am not sure how you might address it, if you choose to, but I do feel it is worth pointing out.
Thank you as always for your thoughtful analysis of these matters.