AIMCo’s $3 Billion Volatility Blowup?

Leanna Orr of Institutional Investor reports on AIMCo’s $3 billion volatility trading blunder:
The Alberta Investment Management Corp. — which manages pension assets, sovereign wealth, and other public money — lost billions of dollars on wrong-way volatility trades when markets crashed earlier this year, and then shut down the strategies, according to informed sources.

The now-defunct volatility-trading program cost pensioners and Albertans about $3 billion, the sources said. That’s on top of substantial, first-quarter losses to portfolio value that nearly all public funds are dealing with amid the coronavirus crisis.

“It’s not very hard to lose $3 billion selling volatility,” said one quantitative hedge fund manager who frequently trades with the likes of AIMCo. “You’re doing stuff that has a minus-infinity potential outcome.”

Another highly complex strategy — AIMCo’s derivative-based “portable alpha” overlays — may have exacerbated the bleeding, according to one of the sources.

AIMCo wouldn’t comment on these or any other strategies, but pointed to extraordinary challenges in markets this year.

“The level of volatility that markets experienced in March 2020, the result of the Covid-19 pandemic, during which volatility rose faster, and on a more sustained basis that at any other time in history, is exceptional,” communications director Dénes Németh told Institutional Investor in an emailed statement this week. “AIMCo acknowledges that it is not immune to the challenges, unique as they may be, that institutional investors around the world have experienced.”

Indeed, many retirement systems and nonprofits reaped years of steady returns by investing in asset managers that sold options or other forms of short-term risk insurance. But when markets blew out, a number of these funds blew up.

Only a handful of institutions run their own volatility-trading strategies in-house, and the vast majority of them are Canadian. AIMCo provides virtually no public details about the program, which a portfolio manager named David Triska takes credit for building at least in part, according to his LinkedIn profile.

Triska claims that he managed and developed “three equity volatility strategies across global developed and emerging markets” at AIMCo, using historical options data, volatility surface estimation, and methodology inspired by at least three types of stochastic volatility (Gatheral, Heston, and Bates), among many other items.

Canada boasts some of the world’s most sophisticated and best performing public investment funds, which essentially operate like Wall Street firms but siphon profits to ex-bus drivers and retired nurses.

AIMCo is not among that top tier, experts and data suggest.

For example, the Ontario Teachers’ Pension Plan delivered 9.8 percent annualized over the last decade, whereas AIMCo gained 8.2 percent — a gap of more than 1.5 percentage points per year.

Even within its own province, AIMCo has trailed the smaller Alberta Teachers’ Retirement Fund. AIMCo is slated to vacuum up ATRF’s C$18 billion (about $13 billion) or so in assets, despite teachers’ and fund leaders’ protracted opposition. Had this already happened, AIMCo’s wayward volatility trades would likely have hit educators’ pensions. 

The Alberta Finance Minister’s office did not directly answer when asked if it would push ahead with the ATRF fold-in or consider pausing until the chaos clears.

“The transition of ATRF’s assets has not yet occurred and AIMCo operates with full operational and investment independence from the Government of Alberta,” a spokesperson for the provincial Treasury Board and Finance told II Tuesday. “AIMCo has a long track record of outperforming market benchmarks and providing great value to Albertans. We are facing unprecedented times and these are challenging market conditions for all investors. We are confident AIMCo will continue to meet the long-term investment objectives of their clients.”

The full extent of the first-quarter damage will come out in AIMCo’s annual public reporting. But in announcing its 2019 returns, the organization seemed set on controlling expectations.

“Our team is responding decisively in an effort to protect our clients’ liquidity and assets in the near- and medium-term, while still identifying longer-term investment opportunities that will come out of these challenging market circumstances,” said Kevin Uebelein, AIMCo’s chief executive officer, in an April 8 statement. “We know the impacts to their portfolios during these times of market uncertainty will be significant, and we are committed to accountability and full transparency to our clients as we navigate these conditions together.”
Sarah Rieger of CBC News also reports that Alberta public pension manager AIMCo reportedly takes big hit to investments:
The Alberta Investment Management Corporation — the province's government-owned pension management fund — has reportedly taken a major hit due to the impacts of COVID-19 and the drastic drop to oil prices.

The Globe and Mail reported Tuesday evening that sources familiar with the situation say AIMCo has lost more than $4 billion through a volatility-based investment strategy. The story was first reported by Institutional Investor, a trade publication based in New York that follows pension funds.

AIMCo has a portfolio of about $119 billion, which represents hundreds of thousands of Albertans' pensions and accounts like the province's Heritage Savings Trust Fund.

Dénes Németh, AIMCo's director of corporate communication, said the pension manager does not comment on the performance of active investment strategies other than to its clients.

"The level of volatility that markets experienced in March 2020, the result of the COVID-19 pandemic, during which volatility rose faster, and on a more sustained basis than at any other time in history, is exceptional," he said.

"AIMCo acknowledges that it is not immune to the challenges, unique as they may be, that institutional investors around the world have experienced."

AIMCo's portfolio is broadly diversified, he said, adding that it's well positioned in the long-term.

Németh said AIMCo has been in frequent contact with investors to discuss the impact to portfolios relating to the current market conditions.

Teachers pensions not affected, yet

In fall 2019, public sector employees voiced concerns about the future of their pension plans after the Alberta government introduced legislation to lock in pension assets from all public sector plans under AIMCo's management.

Protests erupted, as it was announced roughly $18 billion in assets from the Alberta Teachers' Retirement Fund (ATRF) would be moved to AIMCo, and the new legislation prohibited any public sector plan from withdrawing. That transition has not yet been completed.

In February of this year, the Alberta Federation of Labour voiced concerns that the pension manager was being used to prop up the province's struggling fossil fuels industry at a time when many large investment funds have moved away from the sector.

Matt Wolf, the premier's executive director of issues management, tweeted Tuesday evening that AIMCo operates independently of government.

"From what I understand, 'volatility-based investment program' began well before the UCP (not that it was politically directed in any event),'" he wrote.

AIMCo announced its 2019 results earlier this month, and said its $11.5-billion net investment income hadn't met client expectations for the year, as the return was 0.5 per cent below its benchmark.

It also cautioned of the harder times ahead.

"While 2019 held its own challenges, 2020 is unparalleled with the global economic impact of COVID-19 and an oil price war causing virtually all asset values to be significantly repriced and investment markets to enter a period of sudden and unprecedented volatility," the April 8 press release read.

"Our team is responding decisively in an effort to protect our clients' liquidity and assets in the near- and medium-term, while still identifying longer-term investment opportunities that will come out of these challenging market circumstances." CEO Kevin Uebelein said in the release.

"We know the impacts to their portfolios during these times of market uncertainty will be significant, and we are committed to accountability and full transparency to our clients as we navigate these conditions together."
This morning, I received an email from a former AIMCo employee sending me the II article above and stating he was concerned with the "poor governance and lack of empowerment of the risk management group at AIMCo" (and he specified this goes back to the Leo de Bever days even though he was a bit more receptive since he was an ex-risk person).

Now, I must say, whenever I receive anything from any former employee, I take it with a grain of salt and my antennas go up (does he have an axe to grind?).

Still, a barrage of emails came afterward so I went directly to the source and sent an email to AIMCo's CEO and CIO Kevin Uebelein and Dale MacMaster, as well as to Dénes Németh, the director of corporate communication.

First of all, I was shocked someone leaked this out to the media. Was it a current employee? Someone at the ATRF who caught wind of it? A client looking to air out dirty laundry?

The fact that this leaked out isn't good and I think AIMCo should definitely investigate as to why and how this leaked to the media.

Regardless, now it's out and everyone read it. I was met with the same response as every other media source. Dénes Németh shared this with me:
  • AIMCo’s sole commitment is to its clients, in terms of managing their investments and in providing full transparency with respect to the performance of those investments. Accordingly, AIMCo does not comment on the performance of any active investment strategy other than to its clients or as part of its regular public disclosure processes.
  • The level of volatility that markets experienced in March 2020, the result of the COVID-19 pandemic, during which volatility rose faster, and on a more sustained basis than at any other time in history, is exceptional. AIMCo acknowledges that it is not immune to the challenges, unique as they may be, that institutional investors around the world have experienced. Since the beginning of the year, management has maintained a high-degree of contact with each of AIMCo’s clients to discuss the investment performance impacts related to current market conditions.
  • AIMCo is invested across a broadly diversified portfolio of asset classes and strategies – so far in 2020 some have performed well, while others have not. As a long-term investor, AIMCo is well-positioned to withstand, and not overreact to, short-term market fluctuations, further mitigating against having to crystalize underperformance when it does occur.
  • Over longer-term, four- and ten- year time horizons, we continue to add value to client portfolios. AIMCo has a long track record of outperforming market benchmarks on behalf of our clients, including through challenging market conditions.
Now, some of this is standard pension corporate speak but a lot of it isn't and is legitimate.

Let me share with you what really happened based on what I've seen working at the Caisse and PSP Investments before the 2008 crisis hit both organizations very hard.

AIMCo's volatility trading strategy is nothing new, nor is it unique to AIMCo.

I guarantee you other sophisticated Canadian pensions were also selling volatility in a vol strategy and they too got whacked hard except we will never see it reported in the Globe and Mail.

How do I know this? Because I've seen it firsthand and know for a fact that many Canadian pensions engage in similar strategies and they were making money off this yield-enhancement/ volatility-selling strategy (I'd say 6-8% annually).

Are they just selling out-of-the-money puts and calls on various indexes? Are they using other more complex derivatives (volatility or variance swaps?) which became illiquid as markets seized up?

I can't answer specifics on the strategy itself but I can assure you that volatility-selling strategies have been around for a long time and they will continue to be around for a very long time. Done properly, these strategies make sense, especially for a large, sophisticated pension funds with great balance sheets.

A lot of these pensions are doing the same strategies internally instead of farming it out to hedge funds and paying a ton of fees.

So what went wrong in March? As Dénes Németh points out, the level of volatility the market experienced was unprecedented, rising faster and on a more sustained basis than at any time in history.

Let me decipher. Their value-at-risk risk (VaR) model could have never predicted such volatility with a 95% or even 99% level of confidence.

In other words, nobody could have modeled the volatility we saw last month because it was truly unprecedented and uncharted territory.

"Yeah, but Leo,  you've read When Genius Failed a few times, it's one of your favorite investment books of all time, aren't these guys paid big bucks to worry about risk and black swan events?"

Yes, they are, but in my recent discussion with AIMCo's CIO Dale MacMaster going over their 2019 results, he shared this with me on events that transpired this year:
"Initially it looked like SARS, we thought it would be a V-shaped recovery, and then as it got a lot worse, the bottom in equities fell out, stocks collapsed, the VIX spiked to levels not seen since 1929 or 1987, and even bond volatility exploded. Hedge funds, ETFs, mutual funds, risk parity funds all exacerbated volatility."
No doubt, Dale was aware of AIMCo's $3 billion volatility blowup but he couldn't share details with me.

I believe AIMCo's risk managers understood the risks, he understood the risks, but nothing prepared them for the spike in volatility that actually happened. Nothing could have prepared them because no model can model a complete synchronized shutdown of the world.

However, it is well worth noting that Dale was cautiously optimistic given the unprecedented monetary and fiscal response that has happened and I'm stating this because parts of that volatility strategy might still be active for AIMCo to recoup some of their losses.

What I don't understand is why they didn't pull the plug on this strategy earlier, long before the losses reached $3 billion. Was it because markets moved against it too abruptly and way too fast? No doubt. But I also wonder if there was an illiquidity factor at play here which exacerbated the losses.

These are questions for AIMCo's senior executives and I'm sure the Board and their clients have grilled them very hard to understand what exactly went wrong.

Dénes Németh told me they are extremely transparent with their clients, perhaps too much so (if a client leaked it), and this is exactly how they need to be.

Lastly, I've seen these blowups before at the Caisse and PSP and there were plenty more at large Canadian pensions which were never reported on but they definitely have occurred.

At the Caisse, apart from ABCP, there was a senior portfolio manager responsible for a $1.2 billion loss using complex long-term swaps back in 2008. He got his dose of humble pie but that story was never told properly and it's scandalous how little oversight this individual had when he was engaging in these complex strategies (they basically thought he was a genius until the market broke him and his complex strategy).

At PSP Investments, another manager was engaging in a complex strategy selling credit default swaps and he was quite confident about his model telling me back then "it's statistically impossible" to lose money over an one-year period.

PAFF! The 2008 crisis slapped him and PSP's executives back then and it wasn't pretty (Diane Urquhart's analysis showed that strategy cost PSP $510 million that year). The full extent of that story has never been exposed but I can tell you there were internal grumblings from yours truly and others about complex strategies that were just another form of volatility selling.

It's funny, vol buyers typically hate vol sellers, "they're just picking up pennies in front of a steamroller". But over the last ten years, vol sellers have cleaned up house while vol buyers were hemorrhaging money. Until last March, of course.

Great macro managers know when to sell vol and when to buy vol but again, nothing could have prepared you for what happened last March.

Well, some of us did raise concerns in late January on how asymptomatic transmission was a potential game-changer for this virus and that it would spread like wildfire throughout the world (I guess that never made the risk models at pensions).

But nobody listened to me in late 2006 (or they listened and shrugged me off) and nobody listened to me in late January and nobody is listening to me now on the great market disconnect.

Oh well, such is the life of a lone wolf blogger, you can't please everyone all the time.

As far as AIMCo's $3 billion blowup, it's definitely not good but I wouldn't overreact and read too much into it.

There's stuff I read on Twitter which is complete nonsense:

Do you really think executives at AIMCo were not fully aware of the risks they were taking? That is complete utter rubbish! They were fully aware but couldn't predict the unimaginable. Still, I wonder why they didn’t pull the plug a lot earlier.

What else? That II article above irks me comparing AIMCo's long-term results to OTPP's. Stop comparing results from Canada's large pensions without fully understanding their liabilities, asset mix, hedging policies, leverage they use and a lot more!

Lastly, there's no doubt Canada's top ten pensions got hit from coronavirus across public and private markets but they came into this crisis in great shape and will weather it (but get badly bruised).

Below, Mark Wiseman moderated a panel discussion on pensions and the pandemic featuring Blake Hutcheson (OMERS), Jane Rowe (OTPP), and Kevin Uebelein (AIMCo).

Listen very closely to what Blake Hutcheson says at the outset on the extreme volatility which no risk management team could have predicted. AIMCo now knows this all too well and I'm sure there are others we will never hear about in the newspapers.

Update: After reading this comment, 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.

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.
David also shared this with me:
Why did they not pull the plug? We may never know the complete answer but let me lay out a possible scenario for you.

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.
I thank David Long for sharing these very wise insights with me and I'm certain AIMCo will be explaining their volatility program in detail to all their key stakeholders.

Also see my follow-up comments on why AIMCo is conducting a review of this volatility strategy and the response from AIMCo's CEO..