When 'Bets' Go Wrong
Updated: May 17, 2022
Readers of this column will know I am an advocate for better protection of amateur investors. But what about the professionals who either manage or advise pension funds and other institutional funds?
"Why did the pension fund managers invest in something they did not understand?"
My attention has been drawn to the case of German insurer Allianz’s Structured Alpha funds that plummeted in value as markets tumbled in February and March last year, leading to lawsuits being filed by several US pension funds that had invested.
The lawsuits allege that losses incurred by the plaintiffs were a direct result of Allianz having violated its contractual and fiduciary duties by abandoning risk controls and stated investment mandates.
In response, Allianz says the Structured Alpha funds did not diverge from their investment strategy and that, “While the losses suffered in the portfolio are deeply disappointing, there is no basis for legal liability.”
Sadly, the ultimate losers in the debacle are the members of the pension funds who may now be staring at an unhappy retirement. Court cases notwithstanding, who is to blame?
There is a long history of losses incurred by financial institutions because investment bets went wrong. Long-Term Capital Management (LTCM), a hedge fund launched in 1994, was one such example.
LTCM placed thousands of ‘̨bets’ in financial markets where small inefficiencies – arbitrage opportunities – existed. Throw in huge leverage, and the fund was able to make an annualised return of 33% per annum. At least for the first four and a half years.
Then, in August 1998, Russia defaulted on its debt, causing LTCM’s bets to go against it. Given the fund’s leverage, and the inherent asymmetry in bet payoffs, its price quickly fell, by around 90%.
LTCM and funds like the Allianz range, are open only to ‘sophisticated’ investors – institutional funds, professional investors etc – the reason being they are difficult to understand (many of them use derivative structures that are complex and highly volatile).
This does not mean ‘sophisticated’ investors understand them, just that they are deemed professional and hopefully better equipped to make sensible decisions on complex matters, without the oversight and interference of market regulation that would protect amateurs.
While sophisticated investors can be a danger to themselves, they can also endanger others – in the case of the pension funds investing in the Allianz vehicles, this means the blue-collar workers whose retirement savings they were managing or advising.
The Allianz fund that is the subject of one of the lawsuits held around 800 investments as of end March last year, a third of which were options, many of them so-called VIX options that are particularly volatile. There is a saying that if you meet someone who claims they understand quantum mechanics you have probably met a liar. The same could be said for investors in funds like Allianz that use derivatives for purposes other than hedging.
So why did the pension fund managers invest in something they did not understand?
Comprehensive guidance for pension funds in relation to use of alternatives and derivatives is contained in a report from the OECD and the International Organisation of Pension Supervisors. On derivatives the advice is unequivocal: they should be used for hedging purposes not speculation. The derivatives in the Allianz funds were there to boost returns not dampen them, so clearly fell in the latter category.
There is pressure on US pension funds, and indeed other institutional strategies, to generate high volatility-adjusted returns. They may thus be attracted to funds like the Allianz offering that seem to help them do this, even if the small print warns of high risks.
Advice from consultants can also be poor – had the consultant advising some of the funds with Allianz not recommended they sell in April last year, thus crystallising big losses, they could have enjoyed the subsequent and inevitable recovery in markets and fund performance.
While even the manager and architect of the Allianz funds may not have anticipated the sort of market panic of last spring, the risk warnings in statutory and non-statutory documentation were there for all to see. Proving legal liability will be a challenge.
Closer to home, The Wellcome Trust is a good example of how an institutional fund should be managed. It makes money – and indeed made money last year when most lost – by doing good old-fashioned fundamental research and avoiding ̨’quant’ funds like those mentioned. As its chief investment officer Nick Moakes says: “If a product is not comprehensible, caveat emptor.”
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.