Bloomberg, the Wall Street Journal, and Institutional Investor have published new reports in the last two days on the escalating controversy surrounding CalPERS CIO Ben Meng missing out on over $1 billion in gains1 by exiting a tail risk hedge right before the coronacrash.
Meng’s self-defense is backfiring. Not only is the press exposing more layers of his misrepresentations, but Meng’s dogged refusal to admit error is proof of that he is unfit for his job.
Meng keeps trying to pass of the Big Lie that his decision was sound even if it didn’t pan out well. Nassim Nicholas Taleb, who advises the bigger manager that CalPERS ditched, Universa, has already called out some of Meng’s self-justifications in a video we posted on Thursday.
The latest round of coverage reveals more falsehoods. One of the biggest was that Meng kept insisting that the tail hedges were a bad bet because they were too expensive.
It is certainly true that if you overpay for an asset or an exposure, it’s less likely to work out well. To depict the tail hedges as overpriced, Meng flatly said that tail hedges cost usually cost 3% to 5% of the exposure insured. Bloomberg reported that the Universa hedge cost only 1% to 1.5% of the covered amount when CalPERS had the trade on. So Meng exaggerated the cost by three to five times to try to make it look like a bad deal.3
Either Meng was knowingly fibbing about the economics of these hedges or as some anonymous CalPERS sources have charged, he is in over his head and didn’t even understand what these products really cost or how they worked. There is evidence for both theories.
The fact that Meng keeps insisting, as he did in a video for his department members and again to the Journal, that “Knowing what we know, we would make the exact same decision,” says either his ego is out of control or he’s incapable of understanding how his choice was poor on every front: risk/return, avoidance of liability, and proper procedure in dealing with the board.
Either one suggests Meng is not capable of executing his duties as Chief Investment Officer.
Normally, if a senior officer is performing poorly, he should be monitored more closely. CEO Marcie Frost, who has only a high school degree, no mathematical chops, no financial training, and no investment management experience, is unable to oversee him.2 The Chief Investment Officer used to report directly to the CalPERS board, but the board abandoned that arrangement years ago, in 2014.
Nevertheless, the California constitution makes the board the sole and exclusive fiduciary for CalPERS’ assets, so the board can and should be minding the investment store even if they can no longer fire the CIO.
However, the board has been abandoning its supervision of staff, particularly of investments, over the years. And despite this blow-up exposing the dangers of this asleep-at-the-wheel posture, the board plans to relinquish most of its remaining checks on the investment process at its board meetings next week. We hope those of you in California will object and we tell you at the end of this post how to do that.
Meng’s Nose Is Getting So Long He Needs a Hacksaw
To show that Meng’s determination to ditch the tail risk hedges, made in October and was implemented early this year, demonstrates bad judgment, we need to debunk some of his justifications. As an internal talk and his statements to the media show, Meng claimed CalPERS had superior “alternative hedges” and in keeping those hedges made more money. In fact:
Meng tried to present his “alternative hedges” by using “alternative” as an either/or when he should have kept both. According to press reports, CalPERS had $5 billion in equities hedged. If we take the high end of Universa’s range for the hedge cost, it was 1.5% a year or $75 million. Adding $75 million (or more germane, the roughly $19 million that three months of options costs and fees would have amounted to) to any other position in CalPERS’ portfolio wouldn’t have had a measurable impact. It’s an insult to the public’s intelligence to pretend otherwise. [Update: I forgot that Bloomberg reported the actual costs in its first story: “Public filings show Calpers paid Universa $22.5 million and LongTail Alpha $3.2 million that year.” Recall that $5 billion was the peak amount CalPERS protected; the $22.5 million shows that the amount and possible the percentage cost were considerably lower than our assumption].
Meng’s “alternative hedges” were not hedges but at best garden-variety portfolio diversification. According to portfolio theory, being invested in more asset classes does not increase returns but does reduce risk. But Meng is trying to play on the ignorance of many CalPERS beneficiaries with his word choice. A hedge is protection against specific outcomes.
As Taleb pointed out in an interview with Institutional Investor:
“If you have such a large portfolio, you must have hedges. So the more hedges you can find, the better it is, the more variety. Getting rid of hedges makes no sense…..
“Saying ‘it does not fit an institutional investor’ is flawed. CalPERS is a collection of retirees getting a paycheck. You have a responsibility to those beneficiaries. He’s not hedging Coca Cola or some large corporation. He’s hedging the portfolio for real people. You wouldn’t drive a car without insurance. Nothing can replace your car insurance. It directly covers your liability and clips your tail completely.” For CalPERS, “out of the money insurance is not replaceable by any other instrument,” he added.
Meng cherry picked positions to claim they “made” $11 billion, to minimize significance the tail risk give-up, but those positions cost CalPERS much more in the previous year. It’s perverse to see Meng cavil about at most $75 million of mainly options costs to Universa, yet pretend vastly larger opportunity costs on his lower-risk portfolio components don’t count.
If I were Matt Levine, I might reduce Meng’s defense to: CalPERS owned some safe bonds. So would any pension fund.
The other component that Meng highlights as doing less badly than stocks overall, as confirmed by the Wall Street Journal, was his factor-weighted portfolio, which included lower-vol equities. Taleb dismissed that in his video:
Mr. Meng said he made $11 billion on alternative strategies that sort of offset the losses during this collapse.
I don’t know if you realize that these strategies need to be weighted against what they made or lost before that. Effectively, we think, back of the envelope calculation is so-called mitigating strategy would have lost something like $30 billion the previous year. So you make $11 billion, you lose $30 billion before, not a great trade, and definitely not a great trade if you take that over long periods of time, where you lose in rallies and make back a little bit in the selloff. That’s not a mitigating strategy, that’s something that may work in the portfolio, definitely not comparable to tail hedging.
It is noteworthy that all three articles appeared after we published the Taleb video. Two of them, Institutional Investor’s and Bloomberg’s, quoted from it and were gracious enough to credit the site. None of the CalPERS’ statements in these pieces rebut Taleb; they merely repeat points Meng made in the speech that Taleb addressed, at best slightly reformulating them. So Taleb’s arguments have yet to be refuted, which strongly suggests CalPERS can’t.
Meng grotesquely overstated the cost of the Universa program. There’s no way to unsay what Meng said. Perhaps he thought he could get away with this baldfaced misrepresentation to his troops because Ron Lagnado, his quant maven, was no longer there to call him out.
It’s inconceivable that some staffers didn’t know better by having access to the records and/or hearing of the apparently heated opposition to Meng’s desire to end the hedges, which Bloomberg reported in its original April 9 account.
Meng must be overconfident about his internal information lockdown. All investment professionals were able to see total fund performance data by department and program during the eras of Meng’s predecessors, Ted Eliopoulos and Joe Dear. Meng cut access in June 2019.
Now on to the cost of such explicit options-based tail risk hedging strategy. This type of strategy usually costs about 3 to 5% of the protected notional amount, about half of the expected return of the underlying assets being hedged.
You can see why Taleb felt compelled to respond. Meng is clearly addressing the brouhaha over terminating the Universa hedge and losing out on more than $1 billion. Yet rather than use Universa’s charges, Meng uses irrelevant and misleading ranges rather than the actual costs. And those actual costs would have shown that Meng’s claim that the program was too pricey was a fabrication.
Let’s look at it another way. Recall that CalPERS’ long-standing, far-too-often repeated justification for private equity is that it is the only strategy expected to exceed CalPERS now 7% return target.
Consider this section of the Wall Street Journal story, Calpers Unwound Hedges Just Before March’s Epic Stock Selloff:
Mark Spitznagel, Universa’s chief investment officer, said in his letter to investors that the firm’s strategy can help boost returns if investors stick with it through thick and thin. The strategy’s annualized compounded return since 2008 was about 11.5%, according to the letter.
So if an investor had gotten into Universa’s program in 2008 when markets were already heaving and held on through the recovery, not having the foggiest idea when the next big crash would take place, you would have made 11.5%.4 CalPERS started participating in 2017, so it would have paid far less in what amounted to premiums before getting the payout. It’s annualized compounded return would have been vastly higher.
That is why Wilshire reminded the board last August of the attractiveness of staying in despite the bad optics of ongoing costs. And Wilshire assumed that the exposure might earn only 1000% in a crisis, not the ~4000% reward for investors still with the fund in April.
Meng misrepresented the “research” supposedly backing his view. In his talk, Meng cited what he depicted as two papers. One by Robert Litterman, who has cred as a quant (among other things, he and Fisher Black devised an important refinement to the Black-Scholes formula), can’t be called a paper. As we discussed, it’s an opinion piece which does a remarkable job of getting the economics of investment bank equity market operations wrong. It also seems clueless about the liquidity demands on pension funds like CalPERS which are in a negative cash flow position, as in paying out more in benefits than they are taking in in contributions.
Due to time constraints, including inability to access our former industry-leading options-trading clients on a timely basis for a sanity check, we accepted Taleb’s dismissal of the other paper, which was a bona fide journal article, that Meng also touted, Antti Ilmanen’s Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets? Reader JP depicted the article as completely off point as far as tail risk hedging is concerned:
Second, it’s not clear that Ben read Ilmanen’s paper, who concluded that timing matters with tail risk strategies. More disturbingly, Ilmanen uses VIX futures as the tail risk hedge comparison. These instruments are dominated by ATM [at the market] option pricing, not by tail risk option pricing [which is out of the market]. This is probably what disgruntles Taleb. Apple meet orange.
Third, there is a larger problem: Ilmanen fails to realize that VIX futures are the market price of risk. Any public market index can be replicated with VIX futures and a Treasury bond, so they are not hedging, its simply market exposure.
There is no way to put lipstick on this pig. JP politely suggests Meng didn’t read the paper, which he presumably regards as less damning than reading it and not understanding that its analysis was fundamentally wrong, or actually appreciating that but citing the paper anyhow because for some not-defensible-in-terms-of-expected returns reason, he wanted out of the tail hedges.
Meng shifted grounds. In his video, Meng tried to present his “alternative hedges” as better for drawdown mitigation. That was never what the tail risk hedges were designed to do, as we explained in detail earlier.
Meng’s Inability To Make Good Decisions
Meng’s statement “Knowing what we know, we would make the exact same decision,” is so idiotic as to disqualify him from being in a position of authority. It contradicts his earlier and at least dimly defensible position that it was unfair to judge the results based on 20-20 hindsight.
He is literally saying he’s fine with making choices that have bad outcomes, and would willingly repeat them even if he had the perfect foresight so as to avoid them. Meng would choose to stay in Groundhog Day forever, rerunning the same tape loop.
But this Trumpian bluster is a lousy ruse to avoid admitting to a clearly flawed decision process. Consider:
Meng did not consult his expert, Wilshire. That alone is indefensible. Meng can’t pretend his course of action was sound when he froze out his top adviser, the one with better expertise than anyone in his shop save possibly Ron Lagnado and it’s not hard to infer that Lagnado was opposed.
Meng flip-flopped on the tail hedges. Meng came in as of January 2019. Under Meng, in June, CalPERS increased its commitment to the tail hedge program. There is no evidence of anything happening in the markets or with Universa or the other tail-risk manager, LongTail Alpha, between June and October, to warrant Meng doing a 180. Recall as Meng acknowledged, that the portfolio changes he touted as reducing “drawdown risk” had been decided before he came on board, and the board’s authorization of those changes contemplated the tail hedge program remaining in place.
Meng lied to the board. This is arguably his biggest sin. From the March board transcript:
BOARD MEMBER MARGARET BROWN: Ben, can you tell me how our left-tail investments are performing? Are they performing the way we thought they would in this economic downturn?
CHIEF INVESTMENT OFFICER MENG: Good morning, Ms. Brown. Yes, for any left-tail risk hedging strategy you’re referring to, they should perform well in this kind of a down market, as they were exactly designed to do. And from what we know are most of these strategies are performing as anticipated.
Keep in mind that the only exposures that CalPERS calls “left tail investments” were the tail-risk programs managed by Universa and LongTail Alpha, as well as an internal fund.
The Journal confirms that Brown isn’t alone in thinking the board was snookered:
Stacie Olivares, another board member, said she doesn’t recall being told that the [tail risk] strategies had been dropped.
The Cost of “Wrong Way Meng” and Leaving the Staff Running the Asylum
Since Meng is embodying two of CalPERS worst tendencies, casual lying and restricting access to information. It’s conceivable that their is more risk ordnance set to blow up on his watch.
What we do know is that even under his short tenure, investment office morale has dropped markedly:
Employees who know Meng’s record from his earlier time at CalPERS question his competence:
I always laugh when Marcie touts Ben’s experience as an investor. First when he was in the Fixed Income Department he was the group quant, he wasn’t running any money. He had no portfolios under his control. He did a quantitative finance project with Professor Andrew Lo of MIT during the first part of his tenure in Fixed Income – nothing usable came out of it. He did try to build an analytic suite of tools to provide things such as attribution analysis but they were no better than what the Fixed Income Department was able to get from the BlackRock Aladdin system it uses so there really was no lasting legacy to his work in Fixed Income. If he did actually run Fixed income portfolios it had to have been during his tenure at BGI before it become part of Blackrock. As you know Curtis Ishii ran a very good department and produced significant alpha. If Ben was good at running money Curtis would have given him money to run but he didn’t.
Look at what Ben was involved in when he moved to become the Deputy Head of Asset Allocation or as we call it TLPM [Trust Level Portfolio Management]. Two disasters that he was a part of stand out. First was the fund’s decision to terminate its currency hedging program. The analytics work and Board presentations, in which Ben was front and center, were done in 2013 and the $15 billion FX hedge was terminated in June 2014 right before the dollar started to rally. We’ve kissed away $3 billion on that one. The second thing was the creation of what was called the MAC Partners (MAC standing for Multi Asset Class) program. Another brilliant TLPM idea that Ben was a big part of. Essentially it was CalPERS’ way of bringing hedge funds back into the plan through the back door after we had kicked them out the front door. Performance on that as well as well as pretty much everything else TLPM oversaw was terrible and it was terminated last year.
And from another insider:
It’s even worse than it looks. The better minds in the place are leaving even in the midst of the Coronavirus pandemic. In the last two weeks two of CalPERS best and brightest have quit to go back to the private sector. Ron Lagnado who essentially followed Meng’s career path as the fund’s Fixed Income quant and then became the deputy head of Asset Allocation and is a Caltech PhD has just left to work for an options specialty firm [the very same Universa]. Paul Mouchakka who ran Real Assets and did so much to turn the real estate portfolio around and divest bad assets is going back to his native Canada to be a senior partner at one of the biggest Canadian real estate firms. Meng’s message of one team one dream doesn’t have space for the smarter people in the crew, only for his sycophants.
Adding insult to injury in all this is that Meng signed off on a series of steps that led to CalPERS having a very narrow heavily equity and corporate credit risk centric portfolio going into this debacle. Cash liquidity was taken down to 1% from 4% under Ted Eliopoulos and after dispensing with the tail risk hedge and many other long standing diversifying elements in the portfolio the only thing that CalPERS was left with that didn’t get crushed was a 10% position in US treasuries. Why the “brain trust” felt implementing a “go for it” portfolio 10 years into a bull market boggles the mind.
The fact that Taleb was able to see and respond to Meng’s archived webcast is another proof that his staff is in revolt. The video was not listed on the CalPERS website. You would have to know it was there to find it on YouTube, particularly within what was about a day, unless an insider had sent the URL to Taleb.
Even outside fund managers can discern that either Meng is over his head or at best dialing in his presentations to the board. They’ve noted bloopers like using a normal distribution to describe market returns in a June 2019 presentation when markets are not normally distributed.
In other words, Meng was already demoralizing staff and driving the best people out. How much has his authority plunged as a result of his poor judgment and patent lies about why he ditched Universa and LongTail Alpha?
The board as the sole and exclusive fiduciaries cannot prudently leave $370 billion unsupervised, which is what they are effectively doing, as you can see if you pull up the videos for any recent Investment Committee meeting. Even basic questions are few and far between and the committee chairman can be relied upon to shut down any serious line of questioning before it gets very far.
The status quo was bad enough. Now CalPERS afflicted with the worst crisis since the Great Depression and a Chief Investment Officer who isn’t up to his job.
The board plans to make this dire situation even worse by giving away virtually all of what little authority they retain to staff. You can read the sorry details here.
If you are a CalPERS beneficiary or a California resident, give CalPERS a piece of your mind! State that you firmly oppose the reduction of board investment oversight as a rejection of its fiduciary duty. All you need to do is pen an e-mail that is up to about three minutes of reading time and send it in. Get a cup of coffee, sit down and do it pronto, since the first of the two key board meetings is Monday
Individuals present at the CalPERS auditorium may provide public comment on agenda items at the time each item is heard. Members of the public may also submit written public comments by email to firstname.lastname@example.org. Written public comments should note the meeting and agenda item the comments relate to and shall be read into the record at the time the corresponding agenda item is heard. All public comments shall be subject to CalPERS Pusblic Comment Regulation (Cal. Code Regs. tit. 2, § 552.1.)
Be sure to check the board vote on April 20, because you have two shots at defeating these changes. Even if they are approved at the Investment Committee on April 20, they still need to be voted through by the full board on April 22. So you may need to submit a second round of critical comments and perhaps enlist even more friends and colleagues to join you.
Give them a piece of your mind! And please circulate this post widely and ask everyone you know to do the same!
1 It’s probable that the initial give-up was much bigger than $1 billion. CalPERS would have challenged the Bloomberg figure otherwise.
On top of that, the initial Bloomberg report said CalPERS had missed out on over $1 billion. That was when the profit on the bigger position, run by Universa, was up only 3600%. It was up over 4100% in early April, meaning the lost profits were even greater.
To put this in context, the State of California has given CalPERS two $3 billion mini-bailouts in the form of pre-funding. So Meng wiped out a big chuck of the state’s gimmie.
2 That’s why his pay is higher than hers.
3 It may well be true that other tail hedges cost 3% to 5%. But that’s not the issue. It’s what CalPERS was paying for its hedges, not what other hedges might cost.
4 Note that the 11.5% figure is not the stand-alone return on the its hedges, but in combination with the returned on the hedged position, so it contemplates Meng’s concern about the impact on the hedged position. From Institutional Investor:
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.