Cover story
CalPERS, the $375.8bn (£304bn) pension fund for public sec- tor workers in California was prepared for another downturn. With half its portfolio invested in equities, the scheme imple- mented a tail-risk hedging programme to cover potential losses in the event of a recession. Unfortunately for CalPERS, its chief investment officer, Yu Meng, cut the programme at the end of last year, just months before the outbreak of the Cov- id-19 crisis. As a result, the scheme has lost out on significant gains from the volatility that has hit the markets since. The bulk of its hedging programme was run by Universa Investment, a tail-risk hedging firm advised by Black Swan author Nassim Taleb. Universa’s tail-risk fund returned 3,612% throughout March. Needless to say, Meng is now having to explain his decision, amid allegations that the scheme missed out on $1bn (£810m) in returns in March. The case of CalPERS highlights the challenges institutional investors face during spells of volatility. During the past dec- ade, central banks have dedicated unprecedented volumes of money and energy to keeping volatility at bay, with moderate success. As a result, the standard deviations of major stock market indices such as the FTSE100 and the S&P500 have been relatively limited and while bond markets offer record low yields, volatility has also remained at bay. Indeed, Meng argued, insuring stock market risks with an options-based hedging programme is expensive and, he claims, inefficient for a large-scale institutional investor like CalPERS. This is a challenge many UK institutional investors might recognise.
In good times, downside protection looks expensive, much like paying for car insurance is a nuisance…until you have an accident. But despite historically low volatility due to central bank inter- ventions, there have been occasional and sudden stock market plunges, such as the flash crashes in 2010, 2011 and 2015 as well as the February 2018 crash which indicated that some- thing was bubbling under the surface. Indeed, by the end of last year, 57% of professional investors in the UK felt that vola- tility was likely to rise 2020, according to a survey by HYCM, a broker, while more than 70% of investors in London expressed concerns about sudden market changes.
Underlying these sudden spikes in volatility lies a contradic- tion. Fuelled by unprecedented central bank stimulus, stock markets have risen to new post-2008 crisis highs and bond yields reached historical lows, but the picture becomes slightly less sanguine when looking at the prospects for the real econo- my. Over the past 10 years, GDP growth across developed nation economies failed to keep up with pre-2008 levels. More recently, a sharp spike in US unemployment and gloomy Bank of England forecasts for the UK economy indicate that the economic pain inflicted by Covid-19 is likely to have a last-
22 | portfolio institutional May 2020 | issue 93
ing impact. As a result, concerns are growing that artificially low volatility due to central bank stimulus measures could con- ceal risks in the real economy and contribute to a misallocation of investments. The combination of these two risks could lead to the ultimate volatility trap.
Tragedy of the commons
Another factor that has added to rising tensions is the chang- ing nature of brokerage and liquidity provision in the after- math of the global financial crisis. As banks are facing increas- ingly tighter rules on capital requirements, they have significantly scaled back their brokerage activities, with severe implications for market liquidity.
As a result, the nature of liquidity provision has changed dra- matically, according to Richard Tomlinson, chief investment officer at Local Pensions Partnership (LPP). “Banks aren’t there anymore to provide liquidity because of capital requirements and constraints on their balance sheets. It has changed massively. “A lot of the liquidity is now provided by what you would call hedge funds and high-frequency traders and many of them run themselves in similar ways,” he adds. “Many of those business-
It was over so quickly that it’s almost like it never happened, but when we were actually in it, nothing else mattered.”.
John Roe, Legal and General Investment Management
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