Pension plans investing with Allianz funds see big losses

Unprecedented market volatility in March led to big losses for pension funds invested in absolute-return strategies managed by Allianz Global Investors — strategies that were expected to protect against market sell-offs.

The Allianz structured alpha strategies, which include the Structured Alpha U.S. Equity 500 portfolio, historically have been designed to identify "areas of systematic disagreement with option prices about the probability distribution of future index moves," according to a September 2016 AllianzGI presentation.

That presentation at an investment committee meeting of the $9 billion San Diego City Employees' Retirement System led the pension fund to invest $200 million in the U.S. Equity 500 portfolio. As of Dec. 31, the portfolio's value had risen to $282 million.

But by the time of SDCERS' May 8 board meeting, the portfolio's value had plummeted to $77 million, said Steve Voss, senior partner at Aon Investments USA Inc., in a webcast of the meeting.

At SDCERS, CIO Elizabeth Crisafi said in the same webcast of the May 8 meeting that the U.S. Equity 500 strategy had originally been brought to the board for approval in September 2016, at which time it had a successful track record going back to August 2008. Up to the point SDCERS' board approved the investment, the strategy had generated an annualized net return of 11.6% vs. the S&P 500's annualized return of 8.9%, she said.

When the S&P 500 began to fall in February and accelerated into March, Ms. Crisafi said Aon and staff had reached out to Allianz to see how the strategy was performing in the difficult environment.

"By the end of March, the performance of the strategy had declined 75% vs. the benchmark at -19.6%," Ms. Crisafi said. "This performance far exceeded our risk profile expectations."

Mr. Voss cited a "systematic breakdown in (AllianzGI's) investment process" as the reason for extreme underperformance beginning at the end of February, when Aon put the manager on review. The manager was terminated at the May 8 meeting.

That investment process was designed to be both long and short volatility, according to the AllianzGI September 2016 presentation.

It consisted of taking range-bound spread positions, to sell options that were most likely to expire worthless (short volatility); hedged positions designed to protect against market crashes (long volatility); and directional spread positions designed to generate returns when equity indexes rise or fall more than usual during multiweek periods (long/short volatility).

An AllianzGI spokesman said in an email that the strategies suffered in the face of "unprecedented market turmoil" during March, which led to the decision to liquidate the two highest-target funds, the Allianz Structured Alpha 1000 and Allianz Structured Alpha 1000 Plus.

AllianzGI's structured alpha strategies are separated into categories of aggressiveness. Numerical designations of the structured alpha strategies refer to the additional alpha in basis points above an equity index the portfolio is expected to return.

The spokesman, in responding to Mr. Voss' comments, said Aon "has no basis to suggest a breakdown in the strategy's investment process or risk management function."

"Further, as Aon acknowledged in its comments, the investment process and risk management function have been the subject of Aon's rigorous and regular due diligence efforts both prior to and during their clients' respective investments in the funds, which AllianzGI has gladly participated in to ensure that Aon could make fully informed recommendation to its clients about the strategy and its risk and reward profile," the spokesman said.

"We communicated this decision and explained the reason for the underperformance in an all-investor call on March 25 and in many subsequent one-on-one conversations with clients and their consultants," the spokesman said "We explained to investors that, despite having come through previous market shocks in 2011, 2015 and 2018, and having modeled more extreme scenarios, the speed, scale and volatility of the March market drawdown, together with the significant liquidity squeeze, went well beyond prior market dislocations and impeded the strategy's ability to prevent losses.

"Risk oversight remained in place and actively engaged throughout the market rout. We have sought to explain the reasons for the drawdown to clients and consultants and maintain open lines of communication," the spokesman said.

Munich-based AllianzGI reported a total of €510 billion ($563.9 billion) in assets under management as of March 31. The spokesman said that returns and assets under management for the funds are not disclosed because they are private funds, but noted "the U.S. 250 has a UCITS mutual fund variant in Europe. The dollar denominated version was down 37% in the first three months of 2020 against the S&P benchmark, which was down 21% in the same period."

Outside of the 1000 and 1000 Plus portfolios, the spokesman said the structured alpha strategies remain open to investors.

Erol Alitovski, senior manager, research analyst at Morningstar Inc. in Chicago, said the structured alpha strategies' losses in the first quarter occurred despite being designed specifically to avoid the heavy losses that had hit similar options strategies of other managers in the past.

Structured alpha strategies were supposed to protect from market sell-offs, such as the one in March that resulted from concerns regarding the COVID-19 pandemic. They did so by being both long and short volatility at the same time "by having these long put hedges in place in case there was a big drop in the market to provide protection," Mr. Alitovski said. "Often you see options strategies blow up because they were short volatility, and all of a sudden volatility spikes.

"They didn't try to predict equity markets or volatility," Mr. Alitovski said, "and were active trading options strategies, which is part of the reason they were open to some of the upside," Mr. Alitovski said. "They buy put options to provide protections against these tail events and market protections."

That protection, however, applied to a huge one-day drop that would affect the strategies' ability to trade the options the next day.

The volatility spike during March was unprecedented, including during the global financial crisis, Mr. Alitovski said.

"It also happened so quickly but not quick enough for Allianz's puts to kick in and provide that downside protection," Mr. Alitovski said.

"The severity and the speed of a decline of the underlying asset will have varying impact on options contracts based on different strike prices and different expirations," Mr. Alitovski said.

"Basically, implied volatility didn't spike high enough for Allianz's deeper put hedges to appreciate in value because volatility was much lower on those hedges compared to the closer at-the-money short puts. As for time decay, Allianz's long puts that were closer at-the-money were shorter-dated and began to lose value as they neared expiration," Mr. Alitovski said.

During March, the largest five-day percentage change in the CBOE Volatility index was 151.7%, greater than the largest five-day change of the VIX of 55% during the global financial crisis in the 2008-2009 period.

Full data on pension funds currently invested in the Allianz structured alpha strategies were not available, but a review of the most-recent Form 5500 filings with data as of Dec. 31, 2018, shows the Blue Cross & Blue Shield National Retirement Trust, Chicago, had the largest allocation on file, with $2.4 billion of its $5 billion in assets in seven different series, including $313 million in the 1,000 strategy and $1.4 billion in three equity 750 strategies.

Terrence J. Cooney, vice president of investments and national employee benefits administration for Blue Cross Blue Shield Association, declined to comment due to legal considerations.

Another public pension fund in the U.S. Equity 500 strategy also was hard hit by losses this spring.

The $15.3 billion Arkansas Teacher Retirement System, Little Rock, lost $924 million in value in March from three Allianz structured alpha portfolios. The worst-performing portfolio was the Allianz Structured Alpha Global Equity 500 strategy, which crashed to $206 million as of March 31 from $743 million a month earlier. The Global Equity 350 portfolio's assets fell to $196 million from $411 million, and the U.S. Equity 250 portfolio fell to $100 million from $172 million.

The retirement system's board at its April 6 meeting voted to redeem its investments in all three portfolios based on the recommendation of investment consultant Aon Investments.

Deputy Director Rod Graves did not respond to requests for comment.

Morningstar's Mr. Alitovski said the remaining strategies have all changed their processes after locking in their losses.

"They're not going to trade when the market is moving down because that will expose them to additional risk," Mr. Alitovski said. "They have what they call sealed protection where their put options are much closer to the options that they're selling, so their downside is very limited. It's a much different strategy than what investors originally signed up for."

Limiting the downside naturally limits the upside as well, and it is the early days of the restructuring of the strategy, Mr. Alitovski said. The team managing the strategies, however, remains intact

The Allianz team has "solid intellectual capital" and is a "very solid group of investors," he said.

Noting again that March represented historically unprecedented volatility, Mr. Alitovski said investors need to be aware of the inherent risk of options strategies, how much leverage the strategies take, as well as the complexity of strategies.

Investors should ask themselves: "Do they fully understand what's going on?" Mr. Alitovski said.

"Even though certain options trading strategies think they're protected on the downside, it's almost nearly impossible to predict what the next market downturn will lead to," he said.