‘Amateurish’ Trades Blew Up AIMCo’s Volatility Program, Experts Say

Wall Street banks happily paid Alberta’s public pension fund for crash insurance — and cashed in.

Edmonton, Alberta. (Bigstock photo)

Edmonton, Alberta.

(Bigstock photo)

The Alberta Investment Management Corp. — which manages pension assets, sovereign wealth, and other public money — lost billions by protecting Wall Street banks against an extreme stock market crash, experts said.

AIMCo killed its volatility-trading program in reaction to the blow-out, which has cost Albertans about C$2.1 billion, the organization’s CEO said in Thursday letter.

“While that figure will likely change, we have actively taken a number of steps to limit the eventual loss,” Kevin Uebelein wrote to stakeholders. “Actual losses will not be finalized until the strategy is completely wound down, which should occur by mid-June.”

AIMCo staffers built and ran the now-defunct volatility program, which involved highly complex trades and esoteric derivatives prone to misuse, experts said.

[II Deep Dive: AIMCo’s $3 Billion Volatility Trading Blunder]

In one common trade — of so-called capped-uncapped variance swaps — Wall Street banks paid the Alberta fund to cover unlimited losses in the event of an extreme stock market crash.

Many traders believed that they were effectively getting free money. Banks were paying to get risk off their books in order to pass stress tests regulators imposed after the last financial crisis. But, the thinking went, the insurance would never actually pay out, because such a dramatic crash had never happened.

In trader-speak, these kinds of deals are called “selling the small puts,” and are often described as picking up pennies in front of a bulldozer.

“The capped-uncapped strategy is amateurish,” said Gontran de Quillacq, a vol market veteran who consults for institutions and attorneys when funds blow up. “Selling the small puts is a beginner’s mistake,” according to de Quillacq. “Anybody with experience in options and volatility trading knows that those ‘century-rare’ events happen every few years — much more frequently than the simpler math would tell you. It’s a guarantee. How often should you play Russian roulette? How about with three bullets?”

“I am always shocked when I see supposedly ‘institutional funds’ or money managers getting into those strategies,” he added.

Without knowing the specifics of AIMCo’s positions, he pointed out that “Alberta is a qualified investor. As such, it is expected to know and understand what it is doing. It’s not the job of the sales to know AIMCo’s strategy, which they can’t know anyway. Alberta took a risk that was too large.”

Most American institutions avoid the sector or pay outside firms to trade it for them, with varying results. However, even the leaders of U.S. public funds readily hold up their Canadian counterparts as role models.

The Canada Pension Plan Investment Board and Ontario Teachers’ Pension Plan are among the world’s top institutional investors. And both are well-known and “aggressive” volatility players.

Experts and data put AIMCo on a lower tier of sophistication. The organization may not have understood the risks it was taking. Or AIMCo leaders buckled under pressure mid-crash and killed a thoughtful — if risky — program.

“If you didn’t have the stomach and weren’t prepared for a 40 percent drawdown, you shouldn’t have been involved” in volatility markets, said Taylor Lukof of ABR Dynamic Funds, a successful trading firm, about institutions generally. “If you haven’t properly managed expectations with your stakeholders, you may be forced into suboptimal decisions when vol is really, really high.”

Institutional Investor broke the story of AIMCo’s blunder last week, estimating losses at $3 billion. Other media reports pegged them at $4 billion, which Uebelein pushed back against.

The trading debacle has inflamed Albertans, who already face a woeful economy and mass layoffs as Canadian oil prices hit historic lows.

Uebelein promised that a “thorough review of this situation” has begun, “using both the strength of AIMCo’s internal audit capabilities, as well as outside, third-party experts.” AIMCo initially blamed the stock market, but also expressed contrition.

“Markets behaved in a manner never before-seen and the result was a very unfortunate loss,” Uebelein wrote in the letter. “Let me be clear, the performance of this investment is wholly unsatisfactory and AIMCo’s board and management share the frustration and disappointment of our clients, their beneficiaries, and all Albertans.”