By Guest Blogger Ryan Lewenza
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When I got into the investment industry 25 years ago I was that classic, arrogant, overexuberant whipper snapper who thought because I did ok in university that I knew more than most. But I learned quickly how naive and wrong I was, and that having experience and some battle scars are what is required to survive and excel in this industry.
I started in the industry shortly before the tech crash, but not before I could be approved for my first line of credit and shortly thereafter lose most of it as the tech crash unfolded. That lesson, and others, have taught me to be much smarter and measured about my investment decisions. Singles and doubles are fine by me now versus throwing caution to the wind and going for the home runs.
Apparently, someone at a large Canadian pension fund has not learned these crucial lessons, as news that Alberta’s pension company – AIMCO Inc. – has lost over $3 billion in a derivative trade gone terribly wrong, providing a one-time (hopefully) hit to all its members, largely nurses, cops, and firemen. You know them, our heroes!
Today I’m going to review some high-risk derivative strategies that have gone terribly wrong for investors, and how hubris can lead people to make these poor investment decisions, causing much unnecessary loss and pain for investors.
Probably the most well-known example of these derivative trades blowing up is Long-Term Capital Management, which was a massive hedge fund run by a prominent bond trader, John Meriwether, and a few Nobel Prize-winning economists in the 1990s.
The hedge fund ran an arbitrage strategy, trying to find inefficiencies in the market and then using a lot of leverage on top of it. Their investment strategies were based upon hedging against a predictable range of volatility in FX and bonds. However, their fancy spreadsheets and models failed to account for events outside of this “predictable range” or otherwise known as black swan events. In this case it was a Russian debt default in 1998, which lead to the implosion and demise of the fund and requiring a $3.5 billion government bailout.
Another beauty was the natural gas trade from hell for Calgary-based trader Brian Hunter and the Amaranth fund. I remember reading about this at the time and I couldn’t believe the colossal screw-up and arrogance that led to this disastrous trade.
Brian, apparently a very successful energy trader in his day, began taking on larger and larger bets on the price of natural gas. In 2005 he made a huge speculative bet that natural gas prices would spike during the summer hurricane season. He was right and made over $1 billion in profits on the trade.
Then 2006 rolls around and hubris gets the best of him as he implements the same trade in 2006, but this time with an entirely different outcome. Natural gas prices started falling, leading the trader to double-down on the trade. This proved to be his and the hedge fund’s downfall with the trade losing over $6 billion.
For the huge $3 billion AIMCO trading loss it appears that an analyst or portfolio manager implemented a short volatility trade, where they would profit if volatility remained low. But if volatility goes the other way, they lose, and in this case $3 billion! Clearly someone’s calculator was not working that day.
What’s crazy about this whole thing is another firm, LJM Partners, a Chicago-based hedge fund blew themselves up in 2018 implementing the exact same trade. The fund was implementing these “low vol trades”, shorting volatility and collecting the premiums. All is good until volatility inevitably spikes and then boom, a multi-billion dollar hit. This is exactly why Warren Buffett famously called derivatives “financial weapons of mass destruction”.
What really grinds my gears about this risky strategy is that 2019 marked one of the least volatile years in recent history. Last year the S&P 500 did not endure even one 5% pullback (on average the S&P 500 has three 5% pullbacks and one 10% correction each year) and the volatility or VIX index traded at historically low levels of 11-12 and well below its long-term average of 21. This is exactly why I stated in our 2019 outlook, “That doesn’t mean we won’t see bouts of volatility and sell-offs occurring this year. In fact, I see the potential for higher volatility this year.” Apparently, the pension company did not see this as a meaningful risk for this year.
The VIX Traded At the Lowest Level in Years During 2019
Source: Stockcharts.com, Turner Investments
So what are the lessons from today’s blog post?
First, keep it simple by investing in a mix of stocks and fixed income, and avoid investing in these sexy, high-risk, derivative strategies. As one person said in regard to these strategies, “it’s like picking up nickels in front of a steamroller”.
Second, stop thinking you’re the smartest person in the room and have figured out some new amazing investment strategy that no one else has hit. Trust me, it’s already been done before and the few examples noted above are proof of this.
Third, risk-management needs to be front and centre when constructing portfolios. Sure, not every investment is going to work out, but that’s why you need a mix of different assets and investments to spread out the risk and try to minimize major portfolio losses.
Lastly, don’t just assume your pension, whether it’s private or public, is 100% safe and is going to be there when you need it. AIMCO will likely recover from this major loss and hopefully learn from this experience, but this black swan/global pandemic event and steep market correction shows that anything can happen and that life doesn’t always adhere to “predictable ranges”.
Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.