CalPERS’ Abandoned Tail Hedge Starts a War of Words

Nassim Nicholas Taleb, who rose to prominence as author of The Black Swan, is publicly challenging the California Public Employees’ Retirement System’s rationale for ending its tail-risk hedge strategy. Taleb's 2007 book focused on the impact of extremely rare events.

CalPERS’ ill-timed move led to the pension fund missing out on more than $1 billion in gains from its larger of two externally-managed positions — one overseen by Universa Investments — when markets cratered in March.

Taleb doesn’t manage any investments, but is the scientific advisor to Universa, which specializes in risk mitigation. 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. CalPERS told Universa last October to unwind its tail-hedge program, which the firm did as of January. Another manager, LongTail Alpha in Newport Beach, California, also formerly managed a crash-protection mandate for the pension fund. 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. 

Finance and economics blog Naked Capitalism posted a video of Taleb questioning the validity of chief investment officer Ben Meng’s defense of the move in a webcast broadcast on Wednesday. 

Taleb challenges Meng’s rebuttals, which include that CalPERS had “alternative hedges” in place, as well as relied on traditional diversification of the portfolio. Taleb’s aim, he said in the video, “is to dispel some myths concerning tail risk hedging.”

CalPERS ended the program as part of a larger cost-cutting effort and because of a lack of understanding of how tail hedges work, according to sources familiar with the situation. Meng has defended the move, telling Institutional Investor, “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.”

[II Deep Dive: Nation’s Largest Pension Fund Stopped Paying for Crash Insurance — in January]

The pension fund’s decision and process in dropping the program has spiraled into a major story. A CalPERS’ board member said Meng kept quiet about cutting the tail hedge when asked about it at a meeting in March.

Taleb said in an interview with II, that “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.” 

In response to Meng’s assertion that explicit tail hedging doesn’t make sense for an institution, Taleb said, “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.

“Our mission is to pay retirement benefits to our members over decades. Long before the Covid-19 crisis, we began developing a detailed strategic plan that serves us today and will carry us deep into the future.” CalPERS added that it built a strategy on a number of tenets. “Liquidity management: making sure we efficiently manage the cash on hand to pay benefits and take advantage of opportunities that market downturns present; Centralized governance: building a portfolio that ensures all investments contribute to maximizing our ability to achieve our investment return target of 7 percent; Risk segment work: scalable, effective, inexpensive diversification that can help mitigate the impact of a drawdown; and executing on our strategy: Carefully planning for all potential outcomes, investing strategically across all asset classes, and staying calm and focused at all time as we carry out our plan,” the pension plan spokesperson said. 

According to Naked Capitalism, “In addition to questioning Meng’s understanding of these portfolio hedges, Taleb charges Meng with misrepresenting the supposed hedges that Meng said CalPERS had in addition to the two tail hedges CalPERS abandoned. Meng asserts that CalPERS made $11 billion from these positions. Taleb contends that those investments could hardly be considered hedges; his quick and dirty math says that in 2019, they lost about $30 billion, still leaving CalPERS $19 billion net worse off than if it had left well enough alone.”