Bad Timing Hits CalPERS
A few weeks ago, news broke that the California Public Employees’ Retirement System (CalPERS) had taken its biggest hit since the financial crisis as a result of the recent market collapse.
CalPERS' fund balance shrunk from $404 billion to $335 billion, signaling a loss of $69 billion in just one month.
"It’s not that we didn’t expect it, although it does seem a little unprecedented in the market," CalPERS' CEO Marcie Frost said at the time. "We were planning for a market downturn or correction in the market for the last couple years."
Despite saying CalPERS was planning for a correction the last couple years, Frost failed to mention at the time the pension exited one of its two hedges.
According to insiders, CalPERS removed one of its two hedges against tail-risk just a few weeks before the coronavirus caused the stock market to plummet.
Although the hedge CalPERS did maintain generated "several hundred million dollars" for the pension, the hedge CalPERS exited would've generated more than $1 billion for the fund.
CalPERS Chief Investment Officer Ben Meng said the hedges were terminated because they were costly and other methods were cheaper, more effective and better suited for CalPERS.
"At times like this, we need to strongly resist 'resulting bias' — looking at recent results and then using those results to judge the merits of a decision," Meng said. "We are a long-term investor. For the size and complexity of our portfolio, we need to think differently."
CalPERS was warned about giving up on the hedges at an August 2019 meeting with one of its consultants at Wilshire Associates.
"Remember what those are there for," said Andrew Junkin, consultant at Wilshire Associates, according to transcripts from the meeting. "In normal markets, or in markets that are slightly up or slightly down, or even massively up, those strategies aren’t going to do well. But there could be a day when the market is down significantly, and we come in and we report that the risk-mitigation strategies are up 1,000%."
Last year Meng called for a review of CalPERS' tail-risk hedging as part of a plan to reduce the number of outside managers the fund used. A number of employees at CalPERS were against the idea, but CalPERS decided to redeem its funds from one of the two managers in October, with the position closed in January.
Ironically, the outside manager that CalPERS redeemed its funds from was none other than Universa Investments, which is advised by Nassim Taleb, author of the best seller "The Black Swan." Universa Investments generated a 3,612% return in March and 4,144% return year to date.
The terminated hedge that would've generated more than $1 billion for CalPERS returned more than 3,600% in March, validating the warning Junkin gave to CalPERS' executives and board members.
The other hedge, through LongTail Alpha, was terminated on March 31. Factoring in the hundreds of millions of dollars the hedges cost CalPERS in the years leading up to the pullback, it seems likely the company may not have generated any profits on the two hedges.
So whether the moral of the story is always have a hedge for the most unexpected outcome, listen to your consultant or trust your employees' instincts, CalPERS learned an expensive lesson by giving up on a hedge that cost the fund an immaterial amount compared to the payoff it was intended to provide.
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