As Warren Buffet once said, “Only when the tide goes out do you discover who’s been swimming naked.”I thank Brett Friedman for sharing his insights and published them even though I stated that I'm done writing about AIMCo's vol blowup and will let the process play out now that Barb Zvan and KPMG Risk Management are reviewing it to see what went wrong.
- The Alberta Investment Management Company (C$119 billion AUM), Allianz Structured Alpha 1000 and 1000 Plus ($9.5 billion AUM, est.), and Malachite Capital ($600 mm AUM, est.) all come to mind.
- All three funds pursued short volatility or variance strategies. Despite their claims to the contrary, the losses were predictable and had precedent in other markets.
- AIMCo’s estimated C$2.1+ billion loss should be viewed in the context of their asset base of approximately C$119 billion; the loss is large, and certainly disturbing, but not unheard of in a fund that size and with similar return expectations.
- The broader issue with AIMCo is not the strategy employed, evidently flawed as it was. Rather, it was the decision to pursue such strategies in the first place and the prevailing culture, investor expectations, and management that allowed it to occur.
- In all three cases, the incidents highlight the often-misplaced allure of complex strategies, the proper role of risk management in a fund environment, and unreasonable return expectations.
- Post-loss assessments must address these underlying factors, and not just trade specifics, to be valuable; similar trading debacles, of which there are many, provide valuable lessons to avoid reoccurrence.
- The knee jerk reaction by existing funds may be to employ new risk management controls, metrics, and monitoring. However, if they are too onerous or burdensome, they may jeopardize the ability to meet return objectives.
*****
Serious market disruptions usually claim victims and the latest one stemming from the COVID-19 pandemic is no exception. Not surprising: extreme events produce extreme results. In this case, AIMCo, Allianz Structured Alpha Funds, and Malachite Capital reported losses from short volatility or variance strategies. On the face of it, they all used clever strategies to earn what seemed to be consistent, low risk returns, “picking up small puts” as it were. As we will see, things didn’t turn out quite as expected.
In AIMCo’s case, a fund composed mostly of public sector pension plan and provincial endowment funds, what was surprising was not necessarily the magnitude of the loss but its source: certain “volatility-related investment strategies,” as AIMCo’s CEO, Kevin Uebelein, put it in a letter dated April 30th. He didn’t elaborate any further, but one could surmise that the fund was selling some variety of equity variance swaps. According to him, “markets behaved in a manner never-before-seen and the result was a very unfortunate loss.”
Some perspective is in order. AIMCo is a large pension with an estimated C$118.8 billion in AUM. The loss from the volatility strategies was reported in a letter dated April 30th at an estimated C$2.1 billion (actual losses won’t be known until June when the strategy is completely cut). Although certainly concerning, a 1.8% loss from an individual strategy in a fund that size is not surprising and is to be expected given their return requirements (higher return requires higher risk). In addition, the C$2.1 billion is the loss from just one trade in the overall strategy; one doesn’t know the strategy’s total profitability since it was conceived.
Since such strategies had been reportedly going on for some time, one could surmise they were profitable – except for the last trade, that is. As is often the case with selling volatility, it just takes one volatility blowout to render the whole strategy disastrous. You are only as good as your last trade.
Allianz and Malachite Capital have similar stories. In the case of Allianz, their Structured Alpha Fund 1000 and 1000 Plus funds were reportedly selling insurance against a market sell-off in the short term and buying it in the long term. In other words, they were short puts on US equity indexes. “We are acting like an insurance company, collecting premiums,” said the CEO in a 2016 marketing video. Malachite Capital’s reported strategy was to “capture short-term volatility risk premium…” Like the Allianz funds, they were also short volatility. In both cases, the spike in volatility last March resulted in insurmountable losses and their liquidation.
While the specifics of recent losses may differ from that of other trading debacles, the underlying reasons and symptoms are all too familiar:
1. Inherently flawed strategy that only comes to light during extreme market conditions:
The mission of a Wall St. derivatives salesman is to sell new and clever products that make money for themselves and the firms for which they work. Variance swaps provide an interesting twist to this, however, as they can be considered a “capital relief” transaction. Regulatory mandated stress tests on banks’ capital incentivized them to devise products to get risk off their books.
The product that AIMCo supposedly sold, capped-uncapped variance swaps, did just that, covering unlimited losses in the case of a catastrophic market shock. In other words, they were selling insurance that rarely pays out. Assuming you can accurately assess the probability of paying out and the correct pricing for the premium, it generally works out. Since pensions are long term investors that can supposedly weather volatility swings, both parties should be happy. Add to this that the Bank might actually overpay to meet regulatory requirements, and it would seem like a consistent low risk trade. And most of the time it is -- until it isn’t. Allianz and Malachite seem to be in same boat.
All the traders involved seem to be experienced and intelligent and all were seemingly well supplied with risk and performance attribution metrics. What happened? A few things:From Kevin Uebelein, AIMCo CEO, excerpted from his statement of April 30:
- Underestimating the probability of extreme market moves. As any experienced option trader can tell you, so called “fat tail” events occur with far greater frequency than models predict. Hence, short volatility losses are almost always blamed on unprecedented events, as if to indicate that it was beyond the traders’ control. It wasn’t.
- Ignoring history. Were the moves last March really unprecedented? Unfortunate, yes; unprecedented, no. Commodities, especially energy and power, regularly experience extreme and sudden volatility moves exceeding 100% and are very instructive as to what could happen to short volatility positions under pressure. Traders, especially those on the losing side, like to think that their experiences are unique; they rarely are.
- Faulty theory/logic. As the PM of Allianz’s Structured Alpha Fund put it in a marketing video, “We are acting like an insurance company, collecting premiums.” Although the comparison is tempting, selling variance swaps and volatility is not like selling insurance. Insurance companies sell thousands of policies on different events to diversify and avoid concentration risk. Some will pay out, but the majority will not. That is not the same as selling volatility wherein the risk is concentrated and undiversified. Rather, the funds involved were acting like an insurance company selling only one policy.
- Belief that volatility will remain within a relatively tight band and that increases will be short-lived and manageable; related belief that volatility pricing will remain rational and predictable during extreme market scenarios. It is tempting to believe that things will remain the same quarter after quarter and that one has the resources and experience to handle unexpected and extreme events. After all, volatility sellers could be secure in the knowledge that the VIX had been in a relatively narrow range since 2012. Had they reviewed earlier history, or events in other asset classes, they would have better appreciated that a) extreme volatility events usually appear from nowhere and are always unanticipated, and b) illiquidity usually accompanies them, making hedging or defensive trading difficult and liquidation almost impossible, and c) historically “normal” volatility relationships across time and between puts and calls can become unstable, irrational, and unpredictable under extreme circumstances. These three factors must be part of any realistic scenario analysis. In short, complacency was not merited.
- Trading complex or esoteric strategies whose relation to the overall portfolio is questionable; belief that diversification will mitigate the risk: In the case of AIMCo, just how did a staid pension justify getting involved with short variance swaps in the first place?
“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.”One problem here: selling volatility evidently was not diversifying the portfolio. Diversification has many benefits (some of them debatable) but can break down during periods of high volatility and unstable correlations. In addition, and as noted above, one could make the argument that AIMCo’s short variance trade was concentrating and adding to, not diversifying, overall risk.
Variance swaps are often used to diversify long only equity portfolios. Given the assumption that volatility is negatively correlated with equity markets (i.e., increases as the broad market declines), then buying variance swaps could provide a diversification benefit. So, in theory, it could be argued that variance swaps were an appropriate product for a pension, but from the long side only. Unfortunately, AIMCo was short. One can therefore reach the conclusion that the short variance strategy was a separate, speculative trade whose utility was divorced from the overall portfolio.
The real question not just for AIMCo but for other pensions as well is whether the strategy betrays other, more fundamental issues regarding the management of the overall fund. Are other pensions at risk due to similar, inappropriate strategies? Do other pensions contain similar variance swaps? Don’t bet against it.
At all times, common sense and overall investment objectives should always prevail.
2. Strong pressure, internally or externally driven, to produce “incremental alpha” or to compare favorably with similar funds; the allure of Wall St.’s “latest and greatest”:
Return pressure is severe at all funds and the temptation to dabble in strategies or products outside of the fund’s main investment strategy is strong. In the case of AIMCo, their returns have tended to lag similar funds by as much as 1.5% over the last decade. Recently, politics has also entered the mix. In its latest budget, the Alberta government proposed that management of the Alberta Teacher’ Retirement Fund, as well as some other funds, be shifted to AIMCo. This has been vocally opposed in some quarters, most notably by The Alberta Teachers’ Association union on the grounds that AIMCo’s returns have lagged over the last decade.
Add these two factors together and it leads one to the conclusion that AIMCo was under some pressure to produce higher returns and was susceptible to inappropriate strategies.
There can be a psychological element as well. Arguments can be made about the suitability of short volatility strategies for a pension portfolio, but the desire to trade the most sophisticated and complex products offered by Wall St. should not be underestimated. Wall St. derivatives salesmen are unrelenting and have only the best quantitative and market analyses to make the case. In the case of Malachite, it was reported that a consultant, Fund Evaluation Group (FEG) was actively marketing the fund as a “diversifying strategy.” This is not rare; there is a whole ecosystem of consultants and capital acquisition specialists whose sole job is to recommend and vet new managers, strategies, and offer advice on portfolio allocation. Often, they directly run portfolios as well. Despite their representations of independence and fair-mindedness, their main objective is to make money for the firms for which they work.
3. Improper use of risk management:
Invariably, fund losses are ascribed to “a failure in risk management” or “lack of risk controls.” By definition, that is certainly true, but it is much more nuanced than that. Almost all trading debacles occur in organizations that claim they have world class risk management second to none, well-staffed and qualified risk management departments, and experienced and skilled traders.
The problem isn’t the lack of risk management. Rather, it’s the wrong type of risk management. In too many organizations, risk management is relegated to providing risk and performance metrics for senior management and the Board or tasked with policing limits and compliance directives. Many are staffed with quantitative personnel well-schooled in financial theory but more attuned to risk limitation and control than maximizing risk adjusted return. In addition, many have limited practical knowledge of trading and market realities and therefore have difficulty communicating clearly with investment personnel or telling them something that they don’t already know. Adding to the issue is that sometimes quantitative personnel have almost a quasi-religious belief in risk models, metrics, and related stress tests, regardless of historical precedent or common sense.
The result is that there is often a quiet rift between risk management and investment personnel with neither side understanding nor appreciating the contribution of the other. Rarely does this show up in the due diligence process.
Another issue is that the Board is sometimes provided with risk metrics or commentary that they either don’t fully understand or appreciate. In my experience, Boards receive full and complete risk information (sometimes too much) but mostly rely on senior management to highlight the most important matters. If senior management isn’t communicating effectively with risk management, or is receiving poor risk metrics, the Board will then be surprised when losses occur.
Whatever the specifics, risk management is often an adjunct to the investment process but not really part of it. In the most cynical case, it is for the benefit of investors and provides only a showcase, informational role. In other words, lots of statistics and metrics buried in reports with little understanding of their import.*****
Undoubtedly, the experience of AIMCo, Allianz, and Malachite has caused many funds to re-examine their portfolios and wonder whether they could have wound up in the same situation. For funds that have not yet experienced similar issues, their experiences provide a useful guide on avoiding disaster.
Brett is a very nice and sharp guy. I don't agree with him on everything but I like his thoughts on risk management, Board governance and the lessons history has taught us.
Where I particularly disagree with him, however, is his speculation that AIMCo entered this strategy to "reach for yield"and for political reasons now that the Alberta Government mandated it to manage the assets of the Alberta Teachers' Retirement Fund (ATRF).
I can categorically state this is pure nonsense and that this strategy has been in place for years, comfortably earning 6-8% annualized return before the COVID-19 pandemic hit markets.
Brett Friedman is right, however, that diversification typically breaks down in times of extreme market stress, and AIMCo's short variance trade was concentrated and added to overall risk.
In fact, it wiped out all the previous gains from previous years.
Just look at the chart at the top of this comment, it explains it all, record high volatility index for a sustained period doesn't bode well for selling variance swaps.
It is worth noting, however, that when done properly by an expert team, selling variance swaps makes sense for a sophisticated pension, you can collect great yield enhancement over the years.
CPPIB, OTPP and HOOPP all have volatility programs that sell variance swaps but they manage the risk tightly, size the risk accordingly and have world-class experts managing these programs.
But they too lost money selling vol in March. Leanna Orr of Institutional investor just reported today that CPPIB lost C$700 million betting on market volatility in the year ending March 31, primarily in the final months as stocks crashed worldwide.
I kept asking about Aimco's vol blow-up, and insiders kept telling me the story was bigger than Alberta. And it is:https://t.co/eFwIJgbvB2pic.twitter.com/z53mC7RprL— Leanna Orr (@LeannaO) June 3, 2020
However, Ms. Orr also notes that their tastes in risk and deal structures differ:
For example, AIMCo had great appetite for effectively selling extreme crash insurance, protecting banks from infinite downside in an unprecedented crash. Those trades — called capped-uncapped variance swaps — blew up spectacularly.Losing $700 million on a $400 billion portfolio still hurts and detracts from value add but it's not the end of the world for CPPIB and certainly nowhere near as painful as what happened to AIMCo.
CPPIB, in contrast, prefers to limit its worst-case scenarios, according to sources. “Canada is definitely known for having some of the most sophisticated players, and CPPIB is known for being one of the best,” said one hedge fund manager. “By being in Canada, AIMCo piggybacks on the reputation.”
AIMCo didn't size this trade properly and took risk others didn't. The review process will prove something fundamentally went wrong managing the risks of this program.
That $2.1 billion loss is probably less now that markets have rallied like crazy over the last 50 days and volatility has dropped significantly:
This is the greatest 50-day rally in the history of the S&P 500 https://t.co/IDI1wrJhrS— Leo Kolivakis (@PensionPulse) June 3, 2020
Now that Uncle Fed has unleashed a tsunami of liquidity and is backstopping risk assets, there's a frenzy going on and vol sellers are clipping great premiums, for now.
How long will it last? That remains to be seen but right now, the algos are betting on reopening stocks and buying the great rotation into cyclical shares hook, line and sinker:
Anyway, that's a topic for Friday's market comment but let's just say I agree with those who think markets are suffering a moment of madness:
"Are Markets Suffering A Moment Of Madness?" | Zero Hedge https://t.co/vZXpocIxlj— Leo Kolivakis (@PensionPulse) June 3, 2020
As far as AIMCo's vol blowup, let's wait for the review process to play out and see what comes out of it.
Lastly, on top of Brett's comment above, make sure you carefully read the last four comments I have written on AIMCo's vol blowup:
- AIMCo's $3 billion volatility blowup?
- AIMCo to conduct review of volatility blowup
- AIMCo CEO responds to volatility blowup
- Barb Zvan to review AIMCo's vol blowup
Below, CNBC's "Halftime Report" team discusses their investment strategies and the day's market actions amid ongoing civil unrest and the coronavirus pandemic.