One for the Road

Source: CalPERS

Last week, when Ben and I published our assessment and response to the institutional failures revealed by the COVID-19 pandemic, it didn’t take long for some other suggestions to roll in. I have been thinking about one of the first one someone suggested to me ever since.

Bloomberg’s Eric Schatzker covered it first, I think, or at least it was the first article sent to me. Leanna Orr at Institutional Investor published a good follow-up the next day. The issue was this: CalPERS, the largest pension fund in the United States, had a tail risk portfolio that was meant to defend some portion of its massive portfolio against, well, really bad market events. Among other things, no doubt, they had hired two external managers to construct portfolios of instruments that would be sensitive to those events and convex in its sensitivity. In other words, this is a portfolio that is designed to do better when things get worse – and in a non-linear way.

And then CalPERS took it off. Right before the COVID-19 pandemic’s market impact went into full swing.

So is this an institutional failure of the type we discussed in First the People? An indictment of the narrative of prudence that governs so many large assets owners’ actions? Was it just a garden variety mistake? Or was it a mistake at all?

I have absolutely no idea.

One of the things I can tell you from experience is that nearly every decision made by a large asset owner cannot be considered in isolation from a handful of related, often consequent decisions. But from the outside? Considering those decisions in isolation is nearly always all that we can do.

In reality, big asset owners maintain a roster of defenses against terrible events. Yes, they sometimes hire external managers to implement tail risk portfolios like this. Sometimes they also implement those portfolios themselves, or in collaboration with some of their bank partners. They maintain strategic (and tactical) allocations to investments likely to do well – or better said, which have historically done well – in certain types of shock events to risky assets. Sovereign debt duration exposure for deflationary events. Precious metals for “We are all gonna die, aren’t we” types of events. Trend-following for markets where fear compounds over time. And at times, they judge that their investment horizon is better served by self-insuring, by structurally acting as a collector of insurance premiums paid by investors with shorter horizons rather than a payer.

I don’t know whether taking off the hedge was a judgment based on the belief that the specific structures provided sub-optimal protection, or the belief that they could implement them more cheaply themselves, or the belief that they would be better served by simply taking down risk exposure, or the belief that increasing tactical allocations to assets like treasurys and trend-following strategies was better, or a shift in philosophy to that of an insurance premium collector. There are a lot of reasons a decision like this gets made. Usually more than one. And yeah, one of those reasons is sometimes that they were just tired of the constant drag from paying premiums.

I don’t know what the mix of reasons was here.

But I do know this:

In the pre-pandemic world, it was nearly impossible for a professional entrusted with capital to justify paying explicit or implicit premiums for anything that didn’t show results in fewer than five years. Certainly over ten years or longer. Between 2009 and 2020, there was no sin greater than a ‘constant drag on returns’. Yay, efficiency!

The explicit premiums that create a ‘constant drag on returns’ are more obvious. That’s what CalPERS paid. That’s what Wimbledon paid. But implicit premiums that didn’t serve the meme of Yay, Efficiency! were under constant threat as well. They were far more common, too. Financial advisers who kept investors at appropriate levels of risk and appropriate levels of diversification were at risk of being fired every single quarter simply because anything which ‘diversified’ from US Large Cap stocks ended up being ‘wrong.’ Asset owners who maintained deflation hedges or who didn’t rotate from hedge funds (meaning, er, the ones that actually diversify sources of risk) to long-only public equity or private equity exposure were getting slammed in every board meeting, or by alumni suggesting in open letters that they just invest in an S&P 500 ETF.

This isn’t just an investment industry thing. Across the entire American economy, no idea has held anything approaching the power and influence of Yay, Efficiency! over the last several decades. It is the core curriculum in every business school program. It is the ‘value proposition’ of management consultants. It is the money slide of every deal being pitched to achieve scale of one kind or another by an investment banker. It is the entire complex of (non-permanent capital) private equity and private debt investments. It is THE governing meme of The Long Now. Yet if we can learn anything from, say, the millions of gallons of milk being dumped into ditches right now, it is this:

The meme of Yay, Efficiency! is not the same as the truth of long-term value creation.

I don’t have the Answer.

If you need someone to blame, throw a rock in the air – you’ll hit someone guilty. Like me, for instance. I’ve spent a lot of years believing in and working on efficiency. On optimizing. On religiously shunning ‘constant drags on returns.’ Hiring and firing advisers, fund managers and strategists based on my assessments of the pseudo-empirical efficiency of their decisions.

I think I know that there will be institutions who should absolutely still self-insure, who should be structural collectors of premium. I think I know that there will be plenty of closing-the-barn-door-after-the-cows-have-gone pandemic policies written and bought that are more likely than not to benefit the writers and not the sellers. Not everything is going to change.

Still, Ben has written that we have the opportunity now to write new songs of reciprocity and empathy. If so, let us consider rejecting the song that defines our jobs as rooting out everything that might be a ‘drag on returns’ over a 1-5 year-horizon. Let our new song be this: to create things of lasting value.

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  1. Peter Drucker once famously said, “the purpose of any business is to create customers.” Unfortunately, financialization of businesses thru share buybacks etc drives customers away and drives businesses more deeply into debt.

    Companies that were once triple-A rated are rapidly dropping down to the very fringes of “investable.” Wall street applauds reductions in headcounts and phony EBITDA numbers. The question becomes at what point does a business drive off enough customers that it can’t pay its debts? Yay, efficiency!!

  2. The entire ‘outsource to China’ was justified under this efficiency utilitarian drive - they just never realized that the ‘china price’ was cheap upfront, with the costs all backloaded ; now the real bill is being presented, the immense liquidity support and disrupted (& lost) lives and livelihoods…

  3. I always break it down for my clients (and for my own portfolio) this way: I either know the future or I don’t. I don’t - period, full stop. If you want someone who does, please, please, please don’t hire me. Now, since I don’t know the future, what is the best way to invest your money?

    From there, it’s about individual investment goals, risk profile, etc. Then it’s about diversification, re-balancing and tail risk - deflation or inflation spiraling.

    We diversify (taking into account your goals, risk appetite, etc.) since we don’t know what will do well and not and we rebalance as, IMO, it is a real source of alpha over time. Then, we look at the portfolio for the two tail risks - a deflation spiral or inflation spiral. Medium duration US TSYs (and pre-refunded with US TSYs municipals) hedge a deflation spiral (to some extent) and gold and real estate (to some extent), an inflation one. I’m sure commodities do something, but the only thing they’ve ever done for me is cost me money other than the ten minutes they rally strongly which, long term, still doesn’t overcome all the costs of holding them for that rally.

    My point. The fault is less “Yay, Efficiency!” than an unwillingness to accept the limitations of our abilities as investors / money managers. If you can predict the future - go for it and, if successful, you’ll do very well. Actively managed returns argue very few if anyone has a proven track record at doing that. But that is still what almost everyone wants. That, IMO, is the problem. Investors want the future accurately predicted and are mad when that doesn’t happen.

    So, the clients don’t want the truth that we can’t predict the future and there are tail risks that will cost them returns for decades, but you still need to hedge for those risks, so your portfolio will almost always look bad versus whatever investment outperformed recently and/or an unhedged portfolio. And of course, someone would have had you invested in that outperforming asset if you had just invested with them.

    So, since the clients don’t want the truth - and there are always many managers willing to tell the clients what they wants to hear - the industry doesn’t tell the clients the truth and we end up where we are: chasing returns, mouthing slogans like “Yay, Efficiency” or “diversification.”

    I don’t see any new song that will result in clients accepting underperformance for years because you’ve built them a portfolio that diversifies their risks and hedges tail risks because there will always be a “smart” manager telling them how much better they could have done for them.

  4. Tapping into the recent Minimax Regret discussion: What was the bigger regret of a pension fund? Achieving annual returns of 1% below target, or suffering a drawdown much larger than the fund can handle? Seems hard to believe that in an environment (2019) where Buffet’s Q was indicating negative returns over 10 years that removing a drawdown hedge was prudent for a manager with at least a 10 year time horizon.

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