Bloomberg broke an important story last week on how CalPERS’ Chief Investment Officer Ben Meng sabotaged a $1 billion payday on a hedging strategy in the coronacrash. The public pension fund exited the bigger of the two tail-risk programs early this year, right before the markets nosedived.
The Bloomberg account contained the damning detail that Chief Investment Officer Ben Meng had overridden the advice of its consultant, Wilshire Associates, in taking this action.1 Even worse, as we reported, Meng lied to the board in March. Asked by Board Member Margaret Brown about how the hedges were doing, Meng said they were “performing as anticipated” when they’d been largely terminated.2 Lying to the board, beneficiaries, and taxpayers should be grounds for termination.3 It’s impossible for staff to be held accountable if they can tell falsehoods, particularly on this scale.
Meng has offered a lame excuse, essentially saying that people who question his costly decision are engaging in hindsight bias. Yes, it’s true that you can make what looks like a sound call and still have bad outcomes.
But that isn’t what happened here. Meng overrode Wilshire in October, when the consultant had reaffirmed the importance of the hedges at a board meeting in August. Wilshire brought the hedges up, apparently because reports were showing losses, meaning what amounted to insurance costs, to stress that the behavior was normal and no cause for concern, and that the positions were valuable on a total portfolio basis.
So Bloomberg produced a smoking gun, showing Meng ignored expert advice.
A new piece in Institutional Investor, The Inside Story of CalPERS’ Untimely Tail-Hedge Unwind, is damning. Even though the tone of the piece is anodyne, it shows <strong>Meng didn’t know what he was doing. Meng holds himself out as an investment expert. Yet he didn’t understand how these hedges operated. Worse, he let the fallacy of where the hedges had been shoe-horned in CalPERS’ accounting drive his decision.
And to compound Meng’s sins, the story also confirms what we had inferred, that Meng was also violating a basic principle of decision theory, that you ignore sunk costs.
Early on, author Julie Segal levels her charges:
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…
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….
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.”
The piece contains additional details, for instance, as to how Universa, the manager of the bigger hedge that was terminated first, recommended to benchmark its program:
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.
Wilshire presumably constructed a way to evaluate hedge schemes like Universa in continuing to bless it.
The story also insinuates that Meng decided to unwind the schemes merely because they were instituted under his predecessor, Ted Eliopoulos, much the way Donald Trump has reversed every Obama initiative he can lay his hands on:
CalPERS’ decision to establish a crash-insurance policy goes back to 2016 under previous CIO Ted Eliopoulos…
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.
But this part is the real howler:
“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.”
This is patently false.
First, the Institutional Investor and Bloomberg pieces demonstrate that Meng’s “high cost” assertion reveal an embarrassing lack of understanding of these hedges and options pricing generally. Nominal costs and real costs in terms of the value of the hedge are two different matters. This is a “put foot in mouth and chew” level remark.
At best, Meng is saying CalPERS’ dopey metrics and incentives mean the fund can’t tolerate any program that doesn’t deliver positive returns, year in, year out. That’s at odds with this pious “long-term investor” and “think differently” blather. Sticking with the hedges is thinking differently. Dumping them is being hostage to bad accounting.
Second, there’s no evidence to support Meng’s assertions about scalability. CalPERS was planning to increase the size of its participation in these hedges, which suggests that in the range of exposures the giant fund was interested in, there was no penalty for taking a bigger bite. I don’t know how these hedges are constructed, but the use of the S&P 500 as the benchmark suggests S&P 500 futures and/or options were the main instruments used to construct the hedges. Those are deep markets, at least if you steer clear of long-dated positions.4
Third, Meng’s assertion that CalPERS had better hedging options does not hold up to scrutiny. If that were really so, he should have been putting them on as CalPERS was exiting the Universa hedge. So it looks as if he is trying to sell the naive view that traditional risk-reduction approaches can cope with a crisis. As we saw in 2008, they don’t.
As the quants put it, all correlations move to one. Everything moves together, as in down, except the safest of positions, Treasuries (and in that crisis, yen). Remember that the supposed sure bet, gold, went to $660 at crisis bottom. There is simply no way CalPERS would ever hold enough in Treasuries on an ongoing basis to provide enough protection in a market collapse. The same way CalPERS saw itself as unable to stand the small but ongoing cost of the crash insurance, it would find it even harder to tolerate holding enough of its portfolio in Treasuries to constitute adequate insurance against a financial crisis. Oh, and in this crisis, Treasuries have proven to be disconcertingly volatile.
Finally, Meng, like many securities brokers, has been pushing “hold the course” advice. This is where he starts needing to think differently. The not-panic-prone Financial Times today has two articles by seasoned commentators, the highly respected Mohamed El-Erian on Markets and economists are still too upbeat on coronavirus, and the pink paper’s chief economist, Martin Wolf, in The world economy is now collapsing. From Wolf’s analysis:
In January, the IMF forecast smooth growth this year. It now forecasts a plunge of 12 per cent between the last quarter of 2019 and the second quarter of 2020 in advanced economies and a fall of 5 per cent in emerging and developing countries. But, optimistically, the second quarter is forecast to be the nadir. Thereafter, it expects a recovery…
This “baseline” assumes economic reopening in the second half of 2020. If so, the IMF forecasts a 3 per cent global contraction in 2020, followed by a 5.8 per cent expansion in 2021. In advanced economies, the forecast is of a 6.1 per cent contraction this year, followed by a 4.5 per cent expansion in 2021. All this may prove too optimistic.
The IMF offers three sobering alternative scenarios. In the first, lockdowns last 50 per cent longer than in the baseline. In the second, there is a second wave of the virus in 2021. In the third, these elements are combined. Under longer lockdowns this year, global output is 3 per cent lower in 2020 than in the baseline. With a second wave of infections, global output would be 5 per cent below the baseline in 2021. With both misfortunes, global output would be almost 8 per cent below the baseline in 2021. Under the latter possibility, government spending in advanced economies would be 10 percentage points higher relative to GDP in 2021 and government debt 20 percentage points higher in the medium term than in the already unfavourable baseline. We have no real idea which will prove most correct. It might be even worse: the virus might mutate; immunity for people who have had it might not last; and a vaccine might not be forthcoming. A microbe has overthrown all our arrogance.
This shock is already worse than the 2008 crisis by so severely damaging the real economy, which is much harder to fix that propping up banks. It’s well on its way to being this century’s Great Depression. And after the Great Depression, it took equities 20 years to recover. What becomes of CalPERS if that happens again? Is CalPERS running anything like the IMF scenarios to see what they might mean for the giant fund? I doubt it.
Meng needs to stop sticking his head in the sand and relying on the hope that things will return to the old normal. They won’t. But this sorry episode with the tail-risk protection shows that Meng not only greatly overestimate his acumen, but then lied to cover his incompetence.
The reality is that CalPERS isn’t much better than the typical not-all-that-well-managed public pension fund, despite having the heft and the brand veneer to be able to do more and do it better. And reflecting CalPERS’ status as a declining organization, it relies more and more on secrecy, obfuscation, and spin rather than focusing its energies on cleaning up problems and building capabilities.
1 This is important not just from a competence standpoint but even more important, a liability perspective. Investment management is all about liability avoidance, which means following what your professional advisers tell you to do.
2 The honest response comes from the lyrics of a song:
I don’t know
What she’d doing
All I know is she’s not doing it with me.
3 Former Chief Operating Investment Officer Wylie Tollette quit after a series of lies, including that CalPERS could not determine how much in paid in carry fees and later, even after PE Hub was on the story, persisting in misrepresenting how much CalPERS had lowered its investment expenses (see our 4 Lies in 25 Seconds: CalPERS’ Wylie Tollette, PR Staff, Keep Cooking Cost Numbers Despite Being Called Out). In both cases, the fund eventually walked back its position. Tollette, widely understood to have an eight figure net worth before he joined CalPERS, returned to Franklin Templeton, apparently due to his unwillingness or inability to tell the truth about what he was doing. Unfortunately, with Marcie Frost actively promoting a culture of casual lying at CalPERS, the giant fund will have to run itself deeper into its ditch before anything changes.
4 Universa and Long-Term Capital no doubt had a point of view on how much to rely on shorter-dated hedges and run rollover risk, versus take on much longer-dated protection. I would anticipate that they were somewhat agnostic, changing the mix based on relative pricing.