Even if the California Public Employees’ Retirement System knew that the coronavirus pandemic was coming, it still would have eliminated its tail-risk hedging strategy, according to chief investment officer Ben Meng.
At a Monday board meeting, Meng said that the cost of running the program, coupled with the implementation of other risk-management strategies, drove the decision to nix the hedge. And those factors are not changed by a market crash.
CalPERS unwound the strategy – designed to protect its investments during downturns — in January. As a result, the public pension fund missed out on a payment of $1 billion after markets cratered in March.
Meng said that CalPERS did not miss out on a payment of that size during Monday’s meeting, but didn’t put a dollar figure on what the program would have paid out.
The unwind has become a subject of consternation for CalPERS board member Margaret Brown and retirement system beneficiaries in recent weeks, snowballing into what board member Jason Perez called “a PR nightmare” during the meeting.
At issue are comments Meng made at a March board meeting in response to Brown’s question about how CalPERS’s left-tail investments were performing in the downturn.
Minutes show that Meng responded: “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 most of these strategies are performing as anticipated.” At that meeting, he did not mention that CalPERS no longer had such a strategy in place.
Meng addressed this exchange during the Monday meeting, noting that he interpreted the question as a general one on CalPERS’s risk-hedging strategies, rather than on the specific tail-risk hedge it had unwound. He also said that the program was small in comparison to CalPERS’s total investment portfolio — about a quarter of a percent of the size — which meant it didn’t rise to the level of “materiality” that would necessitate alerting the board to any changes.
Brown posted on Facebook earlier this month that the board was never told that the tail-risk hedge was unwound. This issue was the subject of several public comments read during the meeting, which were hostile toward Meng.
Brown’s peers on the board said that they would have preferred being contacted directly about these issues, rather than someone posting their concerns online.
An email forwarded by Brown late Monday to Institutional Investor shows that she requested meetings with CalPERS CEO Marcie Frost on March 31, April 1, and April 11. A spokesperson for CalPERS said that Frost responded April 11, and that the two then spoke by phone.
Tom Toth, managing director at CalPERS’s consultant Wilshire Associates, encouraged the retirement system to be transparent, both with its board and beneficiaries.
“I think during challenging market environments like the one we are currently going through, that questions, can and should be asked, regarding how the portfolio is being managed,” Toth said at the meeting. “And I think communication and transparency can be bolstered around that and particularly in these periods of time.”
[II Deep Dive: CalPERS’ Abandoned Tail Hedge Starts a War of Words]
According to Meng, research has shown that for large institutional investors with low levels of leverage, it is not economical to use explicit options-based tail hedging strategies for the long term. “The cost is too high, and the benefit is too low.” He cited a study published in 2012 in the Financial Analysts Journal by chair of the risk committee at Kepos Capital Rob Litterman, as a major source of this information.
He added that the cost of running the program was about half of the expected return on assets being hedged and that CalPERS would have to pay that premium regardless of market conditions. Meng said the strategy cost between three to five percent to run and would return between six and seven percent.
According to Meng, CalPERS also considered scalability when considering whether to continue the program. He said that “it is difficult to gain enough exposure to be meaningful to the size of our portfolio.”
What’s more, he said, CalPERS had better options for risk management, including a 15 percent allocation to factor-weighted strategies and 10 percent to fixed income. CalPERS also centralized its governance structure and built a “balanced” investment framework.
According to Meng, during the market turmoil from February to March, these provided a drawdown mitigation benefit of more than $11 billion.
“If we were to review the [tail-risk hedging] strategy again, we would make the same decision,” Meng said.