No Such Thing as a Free Lunch

Updated: May 16

In my Last Word column in May this year I wrote about investment fund blow-ups,

with a focus on the debacle of Allianz’s Structured Alpha funds, which plummeted in value in early 2020.

"Perhaps he really believed there was such a thing as a free lunch"

I had thought at the time that the key message of the affair was that one should be wary of so-called ‘portable alpha’ funds such as Allianz’s that use derivatives to generate steady outperformance. However, it turns out there was something else. Something that, at first, I did not believe could be true.


A typical portable alpha fund makes money by selling insurance against a big fall in the market over a particular period, say, 30% over a month. If the market does not fall by 30% or more over the month, the fund keeps the premium, which it registers as its investment return for that month, say, 1%.


As long as the market does not fall by more than 30% in any one month, the fund will continue to make this nice, steady return of 1% per month, 12% per year etc. Until, that is, a month arrives when the market plummets and the fund loses half its value because it must pay out on the insurance. This is what happened to the Allianz funds in February and March last year as Covid-related panic tore through markets.


US pension funds that held the Structured Alpha funds incurred big losses and filed lawsuits against Allianz, claiming that the losses were the result of it deviating from the product’s stated investment strategy. While the Allianz funds had certainly fallen sharply in percentage terms, some by as much as 80%, at least the pension funds had themselves stayed within concentration limits. Or so I had thought.


Last month, I discovered that one of them, Blue Cross Blue Shield (BCBS) pension fund, had invested around half of its assets in the highest-risk Allianz fund, the one that fell by 80%.


To make matters worse, it bailed out of the fund in May 2020, crystallising most of that 80% loss. According to statutory documents, the value of the pension fund’s net assets declined by $2.5bn (£1.8bn) in 2020, a fall of 46%. You can perhaps see why, at first, I had thought my calculations were wrong; at the time of writing this disaster has yet to make the headlines.


After checking that my maths was indeed correct, I was left wondering how a conservative pension fund, with all its requisite checks and balances, could end up investing half of its assets in a single, high-risk investment.


I do not yet have the answer, but here is what I do know. In a 2016 interview, BCBS’s chief investment officer noted that the pension fund had beaten its benchmark by big margins over the previous one, three and five years and that 90% of this outperformance was attributable to its portable alpha exposure.


As a result, the fund would increase its allocation to portable alpha strategies over subsequent years to 80% of net assets. “Being quantitative in nature,” he said, “these strategies are very transparent and relatively easy to explain to boards.”


I cannot imagine that the BCBS trustees would have been happy investing half the pension fund’s assets in a single, high-risk, fund, so it appears the CIO did not understand the Allianz Structured Alpha product as he claimed. Perhaps he really believed there was such a thing as a free lunch which, for a CIO, is extraordinary.


BCBS’s absurdly high exposure to Allianz Structured Alpha explains why it is suing its investment consultant, Aon, along with Allianz. Its court filing states that Aon “breached its fiduciary duties when it recommended that the committee maintain a much greater percentage of pension assets invested in Structured Alpha than Aon’s other clients did, despite pointed inquiries from the committee about whether that concentration might create undue risk in a declining market.”


Frankly, I would be astonished if Aon had recommended, formally or otherwise, such a huge allocation to the Allianz fund but then I haven’t seen the evidence.


As for Allianz, it is possible that it had not factored into its theoretical modelling a market decline as extreme as the one in early 2020, but this is not the same as deviating from stated strategy as BCBS’s court filing claims. Proving liability, as I wrote in May, will be hard.


The moral of the story is simple. Avoid complex funds and beware concentration risk. If you think that you do not need to be told this, remember that even the pros can get it wrong.


Published in What Investment





The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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