CalPERS’ Untimely Tail-Hedge Unwind?

Julie Segal of Institutional Investor reports on the inside story of CalPERS’ untimely tail-hedge unwind:
The California Public Employees’ Retirement System had unfortunate timing.

When markets crashed in March, CalPERS missed a payout of more than $1 billion after cutting its crash-hedging program as part of a cost-curtailment effort and because of a lack of understanding of how tail hedges work, according to sources familiar with the situation.

CalPERS was paying about 5 basis points, or 0.05 percent, for the externally managed part of a tail-risk insurance program that protected about $5 billion in assets. In October 2019, as investors worried about the inevitable end of the longest bull market ever, the pension plan decided to end the hedging initiative because it was too costly.

Universa Investments ran the largest portion of the mandate, while LongTail Alpha of Newport Beach, CA, managed another portion. CalPERS gave them the standard 90 days to unwind their positions.

Nassim Taleb, who wrote the popular book The Black Swan in 2007, advises Universa. That firm had disposed of CalPERS positions by January. LongTail’s hedge was in the unwinding process between January 1 and March 31 and may have generated a final distribution of around $150 million to $175 million. Universa and LongTail declined to comment.

CalPERS’ chief investment officer Ben Meng, who came aboard in January 2019, stands by the decision.

“We terminated explicit tail-risk hedging options strategies because of their high cost, lack of scalability, and the fact that there are better alternatives available to CalPERS,” Meng told Institutional Investor Thursday.

“At times like this, we need to strongly resist ‘resulting bias’ — looking at recent results and then using those results to judge the merits of a decision,” Meng cautioned. “We are a long-term investor. For the size and complexity of our portfolio, we need to think differently.”

Tail-risk hedging programs are similar to life insurance. With tail hedges, like any insurance policy, investors pay a small amount each year — a sunk cost — for a large potential payout if the event that is being insured against occurs. This was the crux of the problem at CalPERS, according to sources. There was a lack of understanding of that cost and thinking of it as a management fee of sorts. CalPERS “benchmarked” the tail-hedge program to the generic benchmark for the fund itself. It did not have a customized benchmark, so the 5 basis points just became another cost for CalPERS.

This isn’t the way tail hedges should be assessed, according to Universa, one of the former external managers. “Risk mitigation performance must of course be measured by its ‘portfolio effect’ — specifically, the impact it has on the compound annual growth rate (CAGR) of the entire portfolio whose risk it is trying to mitigate,” the firm told clients in a recent letter obtained by II.

For example, Universa recommends a hypothetical portfolio of a 3.33 percent allocation to its tail-risk product, coupled with a 96.67 percent position to the Standard & Poor’s 500 stock index, a proxy the firm uses for the systematic risk being mitigated.

In the month of March 2020, the hypothetical portfolio showed a compound annual growth rate of 0.4 percent. In March, the S&P 500 stock index lost 26.2 percent at its lowest point, and closed the month down 12.4 percent. For the year to date, Universa’s hypothetical portfolio had a CAGR of 16.2 percent, versus the S&P 500’s 4.5 percent. The model has produced a CAGR of 11.5 percent since March 2008 inception.

According to one source, CalPERS’ tail-hedge program “may have been swept up in a purge of many inefficient active manager programs. But the program was never meant to be under the mandate for these other programs. By design, it loses a little bit of money during good times with a huge benefit during a severe drawdown in equities.”

CalPERS’ decision to establish a crash-insurance policy goes back to 2016 under previous CIO Ted Eliopoulos. The pension system was trying to be cautious as it was still smarting from the global financial crisis, and started evaluating different tail risk managers that year. By August 2017, CalPERS hired Universa and LongTail Alpha. It set up a smaller in-house program to run related strategies, and planned to reassess the program every three to six months to see if it would meet expectations.

The initiative got a few tests, including the market selloff in February 2018, which it passed. CalPERS continued to increase its allocation. Then in the fall of 2019, with a new leader in place, CalPERS cut the program.
Bloomberg also posted a story on how CalPERS missed a $1 billion payday by scrapping a market hedge and of course, naked capitalism was all over it (Yves loves posting negative comments on CalPERS).

I recently covered pandemic hedge fund winners and losers and stated the following:
[...] Yahoo Finance reports that Universa Investments posted an astonishing year-to-date return of more than 4,000% in March following “one of the scariest months on record,” even as the firm issued a stark warning about a still-overinflated market:

You'll recall, I covered Mark Spitznagel's tail risk fund in mid-February when I went over the crash of 2020. Talk about delivering some real tail risk! (he will never produce such spectacular returns ever again in his life and his returns inception to date are less than stellar).
A few things to bear in mind about these tail-risk funds:
  • Ben Meng is right, they are not scalable strategies 
  • They were hemorrhaging money for over a decade as markets melted up
  • Since inception, most of them have delivered very lousy returns and charged hefty fees for doing so
  • There is a "resulting bias" and it looks like a dumb move now but for a pension fund the size of CalPERS, with hundreds of billions under management and a long investment horizon, maybe they felt focusing on tail-risk strategies wasn't worth their attention, and I think this makes sense.
The only thing I would do differently now at CalPERS is start investing in some very scalable macro/ CTA/ Quant hedge funds and focus on scalable alpha they and multistrategy funds offer.

Remember, I applauded CalPERS's move to nuke its hedge fund program back in 2014, mostly because they didn't take it seriously and it wasn't delivering the absolute return target it needed to deliver. I also applauded CalPERS's move to chop its external managers in half in 2015.

Recall the famous words OTPP's former CEO Ron Mock once told me: "Beta is cheap, real alpha is worth paying for. You can swap into any index to gain access to beta for a few basis points."

In other words why pay an active manager big fees for underperforming an index or not delivering absolute returns, especially during a market downturn?

If I were advising CalPERS now, I'd tell them to start ramping up the alpha across private and public markets.

Ben Meng can talk to many of his Canadian counterparts for insights but I'd also recommend he talks to Vincent Morin, Nelson Lam, and Marc-André Soublière of Trans-Canada Capital here in Montreal.

Not only did their internal multistrategy fund led by Marc-André perform well in March, they maintained a fully funded position for Air Canada Pension.

I cannot emphasize enough that we are heading into a very tough period. You wouldn't know it looking at the Nasdaq (QQQ) but this is just another mega sucker rally which will falter once reality sinks in and earnings crater:

So, forget about "tail-risk" funds being advised by Nassim Taleb and focus on scalable alpha generators across private and public markets.

CalPERS is having a big board meeting next week where investments will be covered in detail.

I hope they don't spend too much time on this tail-hedge unwind and focus on the future.

Below, Paul Schatz, Heritage Capital, joins "Closing Bell" to discuss the state of the markets.

I agree with him, there's not enough fear and we're not going back to normalcy. People need to stop drinking the Kool-Aid but admittedly, this liquidity-driven silliness can go on till end of the month (we shall see).

Also, CNBC's "Halftime Report" team is joined by Marc Lasry, CEO of Avenue Capital, to discuss how markets are trading and the outlook for the U.S. economy. Great discussion and he also thinks it will take a while to return to normalcy.