AIMCo to Conduct Review of Volatility Blowup
The Alberta Investment Management Corporation is conducting a review of a volatility-based investment program, which news reports indicate cost the pension manager $3-billion amid market upheavals triggered by the coronavirus pandemic.No doubt about it, AIMCo got scorched on its volatility strategy and the size of the blowup relative to its assets is what is raising eyebrows and concern.
Jerrica Goodwin, spokesperson for the Treasury Board and Finance Alberta, told the Financial Post on Thursday that AIMCo will be doing a review and providing updates to the minister.
The “volatility-based investment program” isn’t a recent strategy and “began well before the current UPC government,” Goodwin told the Post, noting that the pension manager operates independently and at arm’s-length from government.
“We are facing unprecedented times and these are challenging market conditions for all investors,” she said. “It’s anticipated that all institutional investors will have some tough quarters due to the economic effects of the pandemic.”
She added that AIMCo, which had assets under management of almost $119 billion at the end of December, has a long track record of outperforming market benchmarks and is expected to continue to meet the long-term objectives of pension and endowment clients.
Dénes Németh, AIMCo’s director of corporate communications, said he could not comment on the volatility-based investment program or the suggested losses. But he called circumstances in March 2020 “exceptional,” as the “level of volatility that markets experienced … rose faster, and on a more sustained basis, than at any other time in history.”
Németh said the pension giant is invested across a diversified portfolio of asset classes and strategies and that, so far in 2020, “some have performed well, while others have not.”
He added that, as a long-term investor, AIMCo can “withstand, and not over-react to, short-term market fluctuations.” This, he said, can mitigate against having to “crystallize” losses or “underperformance” when it occurs.
Jim Keohane, who retired this month as chief executive of the Healthcare of Ontario Pension Plan, said AIMCo’s losses from stock market declines in the first quarter were probably far greater than the suggested $3 billion losses from the volatility strategy.
“The difference is that that is an unrealized loss and a lot of that would have come back in the recent market rally,” he said. “The loss on this volatility strategy is money gone that is never coming back. It is a permanent loss of capital.”
Keohane said he suspects AIMCo had a short position in volatility taken via swaps.
If this were the case, the pension fund would collect each day that volatility stayed below the level at which the transaction was made and pay out when volatility moved higher.
“The calculation is quite complicated, but an important aspect is that it is non linear — in other words as volatility goes up the loss per point increases,” Keohane said.
“Prior to the recent market decline volatility was trading around 10, and in the crisis it spiked to almost 90 which is the second-highest reading in history. It is still in the mid 40s so you will still be paying away significant amounts every day unless you close out the strategy.”
Keohane said the “opened-ended” risk of such a strategy has been described to him as “picking up dimes in front of a steamroller — most of the time you get your dime but occasionally you get run over.”
The slightly higher levels of volatility reached in 2008 should have been used as a “stress test,” Keohane said, but he added that what transpired was probably well outside risk models that would have been used as worst-case scenarios.
“The event that just occurred is the absolute worst outcome for a strategy like this,” he said. “The issue is that the loss is very high relative to what they could have ever made on the strategy.”
With few, if any, predicting the global economic hit from the pandemic, AIMCo is probably not alone in having investment strategies that aimed to profit from bets on volatility, according to another pension executive who spoke to the Post.
“I would say that most of the large Canadian pension plans have similar programs, of varying size and approach,” said Don Raymond, who was chief investment strategist the Canada Pension Plan Investment Board until 2014 and now has a similar role at the Qatar Investment Authority.
“Selling volatility is like selling home insurance,” he explained. “You take in premiums and every once in a while the house burns down, causing a loss.”
He said such strategies are “sensible for a long-term investor as they have a positive expected payoff, though the ride can be rough and they need to be sized appropriately so you are not forced out of the position early.”
Given recent market conditions, Raymond said a more apt analogy for market volatility might be “brushfires that caused many homes to burn down.”
A loss of $3 billion on $119 billion total portfolio is huge and begs the question: where was risk management in regards to this volatility strategy?
However, as Jim Keohane explains above, even stress testing this strategy using the 2008 crisis wouldn't have told you how bad things would get and he's right, AIMCo lost a lot more than $3 billion in Q1.
And Don Raymond is also right, other Canadian pensions also engage in this volatility strategy using variance swaps but I doubt they lost anywhere near as much as a percentage of their total assets (because they sized this strategy appropriately to reflect the huge potential losses if something goes wrong).
I've already gone through AIMCo's $3 billion volatility blowup in detail. It quickly shot up to be my number one comment ever and I think it's worth going over what David Long, the former CIO of HOOPP and a derivatives expert who is now a managing partner at Alignvest, shared this with me:
Aside from the fact that AIMCo takes risk, and sometimes those risks don’t work out, there are still some aspects of the situation worth knowing more about.David also shared this with me as to why AIMCo didn't pull the plug earlier:
The most obvious is the limitation on risk. The most effective risk management tool is position sizing. Were the positions in keeping with the trading limits set out in the investment policy?
It’s possible that there was a calculation issue in reporting the risk of the program, and even remotely possible that trades went unreported or unrecorded (I am not saying that is the case here, but needs to be reviewed under the circumstances).
With negatively convex strategies, their exposure increases as they lose money. Was there a stop loss and/or a planned exit strategy if things went wrong? Was it executed?
Exiting negatively convex strategies can be difficult to impossible when markets get very volatile, and this should have been known to the people involved. Both the scale and design of such strategies needs to be contemplated very seriously in advance, with strict limits put into place, as they are dangerous by nature.
Often the reasoning for and projected profitability of this type of program eliminates the possibility of this one’s (and many others) apparent end, namely, the distressed stop-out. When one factors in the possibility (likelihood) that the program will end by buying back (closing out) volatility at a massive loss, the apparent gains before that event seem small by comparison.
It’s worth looking at what levels of volatility were being sold. The VIX index, a measure of 1-month volatility on the S&P 500 Index, traded at approximately 14 in the months preceding the COVID crisis, in comparison to its long-term “forever” average of 16. If it was equity volatility that was sold, did it make sense to sell it in presumably large size at a level below its long-term average? Was the thinking that volatility would remain abnormally depressed?
It’s true that many people lost money selling vol in March. It’s also true that money management can be very difficult at times.
However, the reason people are paid millions of dollars annually to manage investments is to not lose money like everyone else does.
As I understand it, AIMCo is a taxpayer-supported entity, at least indirectly. I think they owe all of their stakeholders an explanation regarding the genesis, operation and conclusion of their volatility program. It’s important for stakeholders to understand who is accountable and how such losses were generated. Only after such an accounting is undertaken can one have confidence that this episode was an isolated incident and, perhaps more importantly, that the right corrective measures have been implemented.
Why did they not pull the plug? We may never know the complete answer but let me lay out a possible scenario for you.I thank David Long for sharing these very wise insights with me. He is one of the best derivatives experts in the country and a lot of HOOPP's long-term success was built on his (and Jim Keohane's) insights.
Equity volatility is commonly sold using the standard product for doing so, the variance swap. As you recall, variance is the square of standard deviation. Volatility is a standard deviation. Selling the variance swap means selling the square of volatility.
When volatility spikes, losses to the variance swap seller mount with the square of volatility. Every time vol doubles, losses quadruple. The risk of the variance swap also rises very quickly. Indeed, it is very possible to get to the point that you cannot practically “pull the plug”.
Pulling the plug means finding a counterparty to offload your position to, almost always a derivatives dealer. Because they have certain risk limits and tolerance, they may be unable to offer you an unwind price on your variance swap position. If this happens, you are trapped and have to figure out what, if anything, to do until things calm down enough to get out.
This is why such instruments need to be used with care. Risks can escalate so quickly that they can eliminate the ability to manage them.
But while David is very diplomatic in his assessment, other experts were far less so, sending me emails calling the folks at AIMCo "a bunch of amateurs" and telling me this blowup is a "testament as to how they can't attract talent to Edmonton."
Others are going further, publicly calling for the heads to roll at AIMCo because of this "volatility gamble."
I think that's harsh. I've spoken to AIMCo's CIO Dale MacMaster a few times and he's definitely one of the sharpest CIOs I ever spoken to (trust me, I've spoken to the very best hedge fund managers, if Dale was remotely incompetent, I'd sniff it out in a second).
This is why it makes it that much more perplexing to me as how they didn't size the risk more appropriately and let the losses mushroom. Surely they've recouped some of the losses as markets rebounded back nicely but definitely not all.
Now, AIMCo has to conduct a full review and no doubt the Treasury Board and Finance Alberta will be under pressure to make their findings fully transparent.
I'm fine with that. We can't pay these top pension executives multimillion compensation packages in good times and hide their losses in bad times. It comes with the territory, if you work at a large Canadian public pension, expect some stiff regulatory scrutiny when you lose billions in a volatility strategy.
That's part of the problem, there is increasing pressure at large Canadian pensions to take more risk across public and private markets to outperform the benchmark and justify lofty compensation.
So, when a scalable volatility strategy comes along and makes sense because it can add 6-10% annually as they collect premiums, nobody raises a peep as long as they're all collecting their big bonuses.
But as Jim Keohane rightly notes, the $3 billion in losses AIMCo experienced in that strategy swamps all the gains they made in previous years.
And this begs the question: will there be clawbacks in the compensation of the people who benefited the most from this volatility strategy over the years?
Of course not. This is what irks me. Some of us have to fight for every basis point in markets and risk our own capital, not speculate on the billions provided by captive clients.
Where are the pension clawbacks? Nowhere to be found in a rigged game where losses are effectively "socialized" and executive bonuses are paid out in good and bad times.
That's why everyone is scrambling for a senior job at Canada's large pensions. As Derek Murphy, PSP's former Head of Private Equity, once told me: "it's the best gig in the world."
No doubt, it certainly was for him and plenty of other pension aristocrats but we need to make sure risks across public and private markets are aligned with the long-term interests of their members and stakeholders, and if there are significant losses on questionable strategies, then conduct a full review and where warranted, compensation should be cut/ clawed back and people should be fired.
I'm sure heads will roll after this review at AIMCo is conducted but as is often the case, someone down the totem poll will be made a sacrificial lamb, given a nice package to stay mum and threatened if they dare speak to anyone, they'll never find another job in the pension industry again.
I've seen it plenty of times and it happens everywhere, not just at large "sophisticated" pensions.
Lastly, as if AIMCo's $3 billion volatility blowup wasn't bad enough, a report published last week by Progress Alberta, questions “risky” investments made by the AIMCo into companies with conservative ties:
Jason Kenney’s UCP government transferred control of teacher pension plans to AIMCo last year, a move labour groups criticized as an attempt to prop up unviable oil companies. AIMCo reportedly lost $4 billion in the first quarter of 2020, but the report argues the problems at AIMCo go back much further.OUCH! When it rains, it pours, and while I'm not a big fan divesting from oil & gas (think it's environmental nonsense and runs against pension managers' fiduciary duty), clearly something smells rotten here.
The report accuses AIMCo of “mismanagement” and suggests public sector pensions were used for a “failed oil and gas bailout,” something that benefitted the same junior and intermediate oil companies who “invest heavily in conservative politics.”
“The petro fundamentalism of the right is largely funded by these companies,” Progress Alberta Executive Director Duncan Kinney told PressProgress.
“It’s interesting how the right rails against public services, then when times get tough, they expect public servants to rescue them with their pension money.”
For example, the report notes Calfrac Well Services, a company in which AIMCo invested more than $228 million, donated $50,000 to Shaping Alberta’s Future, a right-wing PAC that explicitly stated on its website: “We support Jason Kenney.”
The report also notes Calfrac founder and chair Ron Mathison donated a combined $235,000 to theUCP, Kenney’s leadership bid and pro-Kenney PACs, including the Alberta Advantage Fund, Balanced Alberta Fund and Shaping Alberta’s Future.
AIMCo has also invested in Western Energy Services — which, the report notes, is also chaired by Mathison.
As another example, the report points out AIMCo invested $45 million in Whitecap Resources. The report notes Whitecap CEO Grant Fagerheim donated $4,000 to the UCP in 2018. Last year, Fagerheim sent a memo to employees warning Alberta could separate from Canada if Andrew Scheer’s Conservatives lost the election.
AIMCo also invested $49 million in Perpetual Energy, which lost 99% of its value following the investment. Its CEO, Sue Riddell Rose, was appointed to Alberta’s “Red Tape Reduction” panel by the UCP government.
Rose is a prominent conservative donor, reportedly giving $41,000 to conservative parties and leadership races over the past decade. Her late father, Clayton, founded Perpetual Energy and funded a $15 million political school that was set-up with help from the right-wing Manning Centre.
While AIMCo operates at arm’s-length from the government and flatly denies its investments are influenced by politics, Kinney says it does help illustrate how “the modern conservative movement” has been built on the backs of Alberta’s public sector workers.
“Never underestimate the power of the rich to inveigh against working class people while simultaneously benefitting from the power of the state to get even richer,” Kinney said.
Criticism aimed at AIMCo is also being echoed by those in finance.
“This is a total disaster and it brings into question the competence of the managers,” Robert Ascah, a pension expert formerly with ATB Financial told PressProgress.
While the exact cause of the loss is unknown, the report notes AIMCo had a less-than-stellar track record before its control over pensions was expanded by the UCP government.
The Local Authorities Pension Plan (LAPP) even noted: “As measured by quarter ends, AIMCo has been short of LAPP’s SIPP-specified value added expectations for 45 consecutive quarters, or 11 years and 3 months.” According to the report, that partly owes to AIMCo opting to invest in junior oil and gas producers with low returns even before the 2015 oil price crash.
Of the 32 investments made under the Alberta Growth Mandate, the report found 24 were in oil and gas and spread across 14 companies.
Of those, the report points out:
“Every single publicly traded oil and gas company that AIMCO has invested in under the Alberta Growth Mandate has seen its share price go down since AIMCo’s investment, even before the COVID-19 pandemic.”Bill 22, introduced by the UCP last fall, transferred several pension funds to AIMCo, including the Alberta Teachers’ Retirement Fund (ATRF).
“The ATRF and the Alberta Teacher’s Association had reservations before about being forced to invest in AIMCo, and recent events have only heightened those concerns,” former ATRF board member Greg Meeker told PressProgress.
“As a teacher, I have concerns about AIMCo’s governance arrangement,” he added. “From what’s being reported, AIMCO did not understand the multi-billion dollar investment strategies they embarked upon.”
“That’s beyond the pale.”
Moreover, one of AIMCo's largest clients, the Local Authorities Pension Plan (LAPP) isn't too pleased with its long-term performance or governance, which is now spilling over into the debate as to why AIMCo will manage the assets of Alberta Teachers’ Retirement Fund (ATRF).
I still think this proposal makes sense but first AIMCo needs to come clean on what exactly went wrong with this volatility strategy and why they invested in a bunch of junior and intermediate oil companies in Alberta (the full report is available here).
Below, CNBC's Kelly Evans is joined by Spencer Jakab, editor of The Wall Street Journal's Heard on the Street, to discuss oil companies amid volatility in the sector. Not surprisingly, he sees a lot more bankruptcies ahead in this troubled sector.
And Steve Anderson, Vice President, Equity Derivatives and Collateral Management at HOOPP, wrote a tribute song for his friend and mentor Jim Keohane on the occasion of his retirement as CEO of HOOPP. Unfortunately he was unable to play it live for him so he posted it on YouTube for everyone to see, especially those who know him. Love it, great job, Jimmy K is a great all-round derivatives guy!
Update: Another Canadian derivatives expert shared this with me concerning AIMCo's $3 billion volatility blowup:
I know they traded cap var vs uncapped var on the SPX. They were short tail risk on SPX. They probably hedged it with a daily-weekly variance spread where you are long daily var and short the weekly var.I thank this person for these great insights and as far as private markets, the jig is up, private equity's Minksy moment is here and it will roil private and public markets for the foreseeable future.
This trade worked very well in 2008 because SPX was super volatile on a daily basis but on a weekly basis a lot less because market would retrace a lot. In March, it was a straight line down. So their hedge probably cost them a lot of money!!!
I know Barclays had a structured product on SPX variance. It was a straight line up. We looked at it but if you read the fine print you could lose more than the notional you invested! So if AIMCo had this, they didn’t do their homework.
When we are pitched these types of trades we want to go the other way. Dealers try to pitch us these bombs and we tell them that if we discover a bomb it’s the end of the relationship. Guess what? We get less visits!
We navigated very well these markets. Sure, we had a couple of trades that were down in vol space in the pension fund. This was truly an historic event. Nikkei and Chinese stock market were controlled by their central banks. Add to that a big Canadian pension fund covered short SPX vol and a few big hedge funds that were also caught off guard.
However, for a hedge fund, it’s a different mandate than a pension fund. We were long single stock vol and equity vol. These trades made over 4 pct for the fund in March. It’s not easy paying theta. Vol was so low that all of our directional bull beta bets (mostly wrong) were all done using options!
Vol was so extremely low before COVID-19. Macro variables were pointing towards a recovery mostly because China was no longer restricting credit. COVID changed all that but it took Italy’s tragic events to change the paradigm.
Hindsight is 20/20 as we say, finance is the most humbling of professions. AIMCo’s trades were typical trades you see in big Canadian pensions. We were selling vol in 2010 and 2012. Especially credit vol! We were the ones that created a structured product where the pension was selling every week a 102% 1-month call on the SPX. We structured the trade where on average we got 1.6% premium. When they expired the same call was fetching 0.3%!
Like you said, there is a time to buy vol and a time to sell vol. AIMCo’s problem is not per se doing the trade but the problem is always the sizing. Yes historically it never happened but you need what I call street smart PMs and a collegial risk department that truly understand the trades.
It's funny that no one talks about the loss in their private markets. Mark to market is never easy! But I think that private markets are just levered beta bets. Do you really think that they are not as risky? The smoothing effect and lack of proper benchmarks makes them appealing. It's funny how on average no one makes true alpha in public markets but in private markets everyone is an all-star!
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