June 1, 2020
Brett Friedman
Managing Partner
Winhall Risk Analytics
· As Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”
· 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 re-occurrence.
· 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.
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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, this 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 the strategyit was conceived. Since the volatilitysuch 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. Regulatorily 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:
· 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 scearios. 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?
From Kevin Uebelein, AIMCo CEO, excerpted from his statement of April 30:
“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 pressure to produce higher returns for some time 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.
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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.
© 2020, Winhall Risk Analytics