The Alberta Investment Management Corp. has completed its review of a volatility trading strategy, known as VOLTS, that resulted in $2.1 billion in losses in the wake of the coronavirus crash.
While the strategy would have been expected to generate some losses in periods of market volatility, the losses were far greater than expected, noted a report on the review.
As the crisis unfolded, the AIMCo’s board took steps to mitigate further losses by approving a plan to wind down and permanently close the strategy altogether. It also moved to review more than 50 other value-added strategies to determine whether any of them also had the potential for outsized losses. It found none of them had the potential to perform as poorly as the volatility strategy.
The report outlined the history of the AIMCo’s volatility contracts strategy, which began in 2013 and was expanded in January 2018 to include capped/uncapped variance swaps. “These swaps trade a relatively fixed return during typical to moderately high volatility conditions for a significantly more steeply tilted and non-linear loss function during high to very high volatility conditions and carry the risk of greatly magnified losses from extreme volatility events, such as the COVID-related volatility experienced in March or that experienced in the October 1987 Black Monday event.”
While the volatility portfolio was shifting towards higher-risk capped/uncapped contracts, the overall portfolio was growing above its pre-2018 levels. As well, a legacy risk system was in place that worked reasonably well for situations with a linear relationship between portfolio investments and underlying economic and market factors. However, it didn’t work well with non-linear returns, like the volatility strategy. “The limitations of the risk system had previously been recognized and its replacement had been identified and was in the process of being implemented,” said the report.
By January 2020, the AIMCo’s risk management team had modelled the risk involved in the capped/uncapped strategy and called for more attention to be paid to the unlikely, but still possible, chance of extreme tail risk. The public equities team started taking action to reduce the fund’s overall exposure to the volatility strategy in early March, but by then it was too late. “Unprecedented and sustained volatility caused by the COVID-19 crisis made it impossible to unwind the positions without considerable loss.”
In response to the situation, the board launched a comprehensive review of the volatility trading strategy. A new report by the AIMCo outlines recommendations and changes as a result of the review.
“Oversight of AIMCo’s investment strategies and risk management is the responsibility of the board of directors,” noted the report. “The losses incurred by our clients as a result of the VOLTS strategy are wholly unacceptable. The board is determined that the lessons from this experience will improve AIMCo’s management processes, prevent any similar occurrences and, most importantly, strengthen the risk culture of AIMCo.”
The board’s review concluded that the degree of challenge from the first and second lines of defence, namely the investment and risk management teams, regarding the strategy was unsatisfactory. And the “breadth and depth of risk governance controls, collaboration and risk culture” were also unsatisfactory. Further, analytics relating to the extreme tail risk inherent to the volatility strategy weren’t escalated to senior management and the board quickly enough.
As a result of the review, the board has adopted — and instructed management to implement — 10 recommended changes. First, that the AIMCo’s chief executive, investment and risk officers will personally lead and ensure the integration of the risk management and investment management staff, progressing toward a more collaborative and inclusive relationship. Second, the AIMCo will broaden its risk framework to deepen its description of risk appetite and risk tolerance, as well as launch a process of dialogue and debate across the organization on these topics.
Further, the AIMCo’s management will propose revised investment approval thresholds relating to any investment strategy or product using over-the-counter options, swaps or other derivatives, with the exception of cases in which derivatives are used only for hedging risks inherent in an investment strategy. As well, regular risk reporting to the board will become more granular by including exposure and risk measures against applicable thresholds and limits for all products and strategies.
Management will also develop an escalation and remediation process whereby risks that may lead to outsized or unexpected losses will be identified, regardless of the risk limit. And the risk management team will provide the approving authority, including an independent review of significant risks, whenever a product or strategy originates, is expanded or changed in terms of design or description.
At the outset, expansion or change in design or description of any strategy or product, the AIMCo will also clearly indicate any risk that an amount in excess of the initial investment could be lost. As well, if a change is made to the design or description of an investment, the original authority that approved the product or strategy will have to re-approve it as though it were completely new.
As for talent management, the board said its human resources and compensation committee will continue its redesign initiatives to push risk and investment managements’ further integration, including provisions for their compensation to be meaningfully linked to both teams’ degree of improved collaboration. The board also asked the chief executive officer to revise the AIMCo’s talent management strategy, organizational design and management succession plan.
In the review process, the AIMCo used its internal audit group and chief legal officer, in addition to third-party advice from Barbara Zvan, former chief risk officer at the Ontario Teachers’ Pension Plan, and KPMG’s financial risk management team.
“No matter how carefully designed a set of prescriptive rules are, a so-minded individual or group can usually find a way to circumvent such rules,” said the report. “Consequentially, the most important changes emerging from the board’s review are actually not process changes at all, but rather changes to the culture in which the rules are to be embedded.
“With the oversight of the board, senior management will continue to move AIMCo’s culture toward a more collaborative environment among risk and investment professionals. These changes are not so easily effected and will require strong focus and leadership from the board and senior management, as well as continuous evaluation against clear, predetermined benchmarks.”