Verdict is coming on risk-mitigation strategies

First-quarter returns are expected to test how asset owners' strategies put in place to protect their portfolios have worked.

The firestorm that lit when CalPERS officials this year acknowledged that they had switched tactics and terminated two tail-risk hedge funds highlighted the variety of ways asset owners have chosen to protect their portfolios from downside risk. The common theme has been to preserve their portfolios from the illiquidity and losses suffered in the global financial crisis of 2008.

"We're just getting first-quarter numbers now," said Neil Rue, Portland-based managing principal and consultant for Meketa Investment Group.

Mr. Rue helped develop Pension Consulting Alliance's risk-mitigation strategy, which is being used by about six clients, including the $239.3 billion California State Teachers' Retirement System, West Sacramento. Meketa acquired PCA last year.

"There's a delta between those who have the (risk-mitigating strategies) in place and those who didn't, particularly in the first quarter," Mr. Rue said.

However, he said "it's early days. People have to examine their first-quarter numbers before making any judgments."

Every asset owner has its own version, he said. The basic structure for PCA clients was a mix of long-duration Treasuries with trend-following and alternative risk premium strategies. Some plans added global macro strategies in some form, Mr. Rue added.

There were indications at CalSTRS' most recent investment committee meeting that their risk-mitigation strategy had done its job so far.

Although the portfolio is flat for the year, it is stable, CIO Christopher J. Ailman told the committee at its online meeting on May 7.

"The creation of the RMS (risk-mitigation strategy) as an asset class, added value where equities have been so weak," Mr. Ailman said.

In November, CalSTRS increased its RMS allocation by 1 percentage point to 10%.

Allan Emkin, Portland-based managing principal and consultant of Meketa, said at the CalSTRS meeting that staff took profits created in the risk-mitigation strategy and redeployed those profits at better prices in the equity market.

The $372.9 billion California Public Employees' Retirement System, Sacramento, took a different approach, said Dan Bienvenue, deputy CIO for total portfolio strategy, in an interview. Unlike its sister pension plan across the river, CalPERS does not have a risk-mitigating strategy asset class. Instead, the pension plan went into the current crisis with a risk approach that included a 10% allocation to long-duration U.S. Treasury bonds and 15% allocation to factor-weighted equities. CalPERS also had been invested in two tail-risk hedge funds, which officials decided to redeem last fall after conducting an active-risk review.

The factor-weighted portfolio did drop 20% in the first quarter, but it did not go down as far as the rest of CalPERS' equity portfolio, which was down 25% between Feb. 19 to the end of March. While it is still early, the factor-weighted portfolio is expected to capture more of the equity market upswing and less of the downturn than CalPERS' cap-weighted equity portfolio, he said.

Like CalSTRS, pension fund officials at CalPERS rebalanced its portfolio to its asset allocation weights after the runup in U.S. Treasuries in March. They sold Treasuries and bought equities to capture the mean reversion premium, Mr. Bienvenue said.

He said that CalPERS' officials, knowing now about the outperformance of volatility strategies in March, would have still made the same decision to redeem the tail-risk hedge funds late last year in favor of relying on its 10% allocation to long duration U.S. Treasuries and 15% in factor-weighted equities as a large portion of its risk strategy. Both of the latter portfolios are managed in-house.

The other two elements of CalPERS' risk strategy are its liquidity management framework and its staff's total-fund focus, both adopted in 2019 from a more siloed structure in which each asset class team looked at the portfolio from the lens of its particular asset category, Mr. Bienvenue said.

In a drawdown or periods of market stress, it helps to think about the plan in a total portfolio way, he said.

CalPERS' decision to drop its tail-risk hedge funds implemented to protect against equity market drawdowns began with an active risk review conducted in 2019, CalPERS CIO Yu "Ben" Meng told the investment committee in April.

In the fall, CalPERS officials decided to redeem its investment in two tail-risk hedge funds, one managed by LongTail Alpha LLC and the other by Universa Investments LP, which together managed $200 million, after those strategies suffered an 82.1% loss in the year ended June 30. Staff first invested in the strategies in 2017 and added to the investments over time, Mr. Bienvenue said.

"After the GFC, we knew we needed the ability to handle drawdowns," he said. Tail-risk hedging was one strategy CalPERS tried.

"In the fall, staff decided to redeem the tail-risk hedging investments based on the cost and the scalability of the strategy, Mr. Bienvenue said. CalPERS had fully exited the strategy by the end of March, he said.

"We found them (tail-risk hedges) to be costly, and the costs became more and more impactful as expected returns were coming down," he said. And the depth of the options market, which is a key part of those strategies, was an issue.

"We could have gotten to $15 billion of assets under protection but that would have been a really big portion of the (options) market and arguably the costs would have gone up," Mr. Bienvenue said. "Those strategies are reasonable strategies for some investors. For us, we felt we had better options."

Together, the U.S. Treasury and the factor-weighted portfolios saved the pension plan $11 billion in drawdowns, he said.

Peak to trough of the most recent downturn, CalPERS' "long-liability government bonds held up robustly," Mr. Bienvenue said.

Executives at Universa say that investors can't compare hedged and unhedged exposure in a vacuum. "Universa's tail-risk hedge, by being highly convex, costs a small amount of dollars in a non-crash and pays off a significantly larger amount of dollars in a crash, and it is this asymmetry of this payoff that matters," said Brandon Yarckin, Miami-based chief operating officer of Universa. "Even if other risk-mitigating strategies make you money, they are not making enough relative to what they are costing your portfolio the rest of the time."

Mr. Yarckin said that Universa's risk mitigated portfolio life to date has outperformed all other risk-mitigation strategies as well as the S&P 500. He declined to provide return information.

However, the Eurekahedge CBOE Tail Risk Index posted a 51.9% for the year-to-date through April 30 and -10.4% for the year ended Dec. 31.

What's more, he said that the options market is sizable.

"The equity options market is incredibly large," Mr. Yarckin said. "While it's hard to estimate the precise size of the options market because most of it is over the counter, it is more than sufficient to provide meaningful payouts for large institutions, including very large pensions, who do meaningful option trades all the time."

Vineer Bhansali, founder and CIO of LongTail Alpha, could not be reached for comment.

Los Angeles County Employees Retirement Association, Pasadena, Calif., also incorporates hedge funds into its strategy. LACERA's risk reduction and mitigation strategy had $14.7 billion, amounting to 27% of the $54.5 billion pension fund as of March 31, according to a report for the board's May 13 meeting.

LACERA's portfolio is made up of $11.8 billion in investment-grade bonds, a $1.3 billion diversified hedge fund portfolio and $1.6 billion in cash.

Hedge funds were recently added to the strategy. The credit portion of the hedge fund portfolio did not perform as anticipated in the recent drawdown, the report noted. The hedge fund program was estimated to have lost 7% to 8% in March, while the HFRX Global Hedge Fund index was down 6%.

The pension plan's risk reduction and mitigation portfolio earned 4.4% fiscal year to date and 7.3% for the year ended March 31, underperforming its custom benchmarks of 5.2% and 8%, respectively.

The $76 billion Massachusetts Pension Reserves Investment Management Board, Boston, risk-mitigation strategy has evolved over time, said David Gurtz, deputy CIO and director of public markets.

"We believe that collectively these risk mitigation and diversification strategies have helped the PRIT Fund (the investment fund overseen by MassPRIM) consistently perform well in both up, and perhaps more importantly, down markets," Mr. Gurtz said.

The pension fund was down 9% for the quarter and 1.24% for the year ended March 31 but up 5.24% for the five-year period and 7.54% for the 10-year period, according to its most recent summary of plan performance. By comparison, public pension plans in the Wilshire Trust Universe Comparison Service produced median returns of -12.81% and -4.78% for the first quarter and year ended March 31, respectively.

In 2019, MassPRIM increased its allocation to core fixed income, specifically increasing its exposure to long-duration Treasury STRIPS and adding a new 2% allocation to short-term U.S. Treasuries, he said. Pension fund officials made their first investment in U.S. Treasury STRIPS in April 2014.

MassPRIM has a target asset allocation of 39.3% global equity, 15% core fixed income, 12.8% private equity, 11% portfolio completion strategies (which includes hedge funds), 10% real estate, 8% value-added fixed income, 4% timberland and zero in overlay.

The evolution of MassPRIM's strategy includes reducing global equities to its current 39% from 50% five years ago. The pension fund created in 2016 a portfolio completion strategies asset class, designed primarily to diversify the overall portfolio by investing in strategies that are not highly correlated to equities, Mr. Gurtz said.

"These investments include non-directional hedge funds and real assets investments such as agricultural, insurance and leasing strategies," he said.

In 2017, pension fund officials incorporated enhanced equity hedge and long-duration Treasury STRIPS into its asset allocation.

"A combination that would allow PRIM to maintain equity exposure while reshaping the distribution of stock returns," Mr. Gurtz explained. "The enhanced equity hedge would be most effective in directionless or slowly trending markets, while the long-duration Treasuries, even at low interest rates (which are of course even lower today), could serve as PRIM's cost-effective tail hedge/crash protection."