Structured Alpha?

One of the largest stories in the last weeks is the guilty plea of Allianz with regards to their Structured Alpha products, which imploded in the Covid-related equity market volatility. As a strategy, this was a darling of the investment community, with assets under management of around $11bn (at different risk levels) and had 114(!) institutional investors as clients across 17 different vehicles (SEC).

Admittedly Allianz was not the only fund that lost money during the turmoil, but the conduct of the manager leaves a fair amount of questions when it comes to performing investment due diligence on complex strategies and maintaining oversight of the strategy. And especially how control functions are working in larger and trusted organizations.

The suite of Structured Alpha products had a number of different benchmarks, but ultimately depended on an option selling strategy (that was supposedly tail hedged) and all of them suffered large losses during the March-2020 market meltdown. In this post, we illustrate the fund with one of their more aggressive strategies, which was packaged into a UCITS structure. Many other vehicles existed.

The SEC document makes for interesting reading about how the Portfolio Managers manipulated the numbers to create an illusion of a strong risk-managed product. As the evidence of mismanagement of the product was impossible to defend against, Allianz ultimately settled for $6bn where $5.1bn goes to compensate investors for their losses and $0.9bn as various penalties to the SEC and DOJ.

Judging from the numbers, this should have made most investors whole and the impact of a disastrous investment decision may have been mitigated by the settlement.

Given Allianz’s large US business, this was perhaps a small price to pay to remain as a US entity for their large US based asset management arm. If those would have been banned from managing money for US clients, it would have spelled even more trouble for the company.

A number of reputable consultants had the Structured Alpha as high conviction recommendations due to the belief that the fund would actually be able to provide uncorrelated excess returns while avoiding the normal curse of volatility selling strategies. Much of this is public information and lawyers will likely continue to earn a good fee from litigating against stakeholders for the foreseeable future.

In the NilssonHedge database, we only have the track-records of the UCITS fund. However, the pnl curve and losses should be indicative of how other investors faired. The strategy generated positive results and managed to take money out of the market in a calm market environment. This strategy raised close to $400mm and was managing around $330mm in early 2020. This particular fund suffered a monthly loss of 50%, erasing all of the historical gains and producing a remarkable loss for investors. Structured but no Alpha.

The underlying strategy, option strategies, and dedicated option writers (aka “equity risk premia”) are difficult to assess from the perspective of their track records. Most track records that investors will be exposed to, will have small incremental gains, only to suffer from larger “unexpected” losses and the strategy stops reporting.

Making research additionally difficult is that these track records are occasionally purged from databases, the last month is rarely reported. Allianz is an exception where they continued to report numbers despite the initial loss.

Based on the data we have, we note that for funds that we started to record in 2018, 71 have shut down, while 14 are still alive. Likewise, for strategies that were incorporated into the database in 2019, 127 have shut while only 9 are reporting numbers and so forth. For a manager that are commercializing their strategies in 2021, we still have more managers reporting numbers than not.

The stock of managers engaging in these strategies typically dwindles during market turmoil. We may see a few additional strategies shut down during the year. However, the continued turnover in the space, with managers using “instant” track records with limited aum, is and will remain a problem for investors.

Consider a turkey that is fed every day, every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.

The Black Swan – Nassim Taleb

Options strategies, and especially strategies that are long “carry”, are difficult to understand. Many sophisticated entities suffered humiliating losses, not only based on the fraudulent perception of star quality from a portfolio management team, but also from their own biases of wanting smooth and steady returns. That perfect life is when we can provide positive returns every month.

This is not the first or the last time option sellers will have catastrophic losses, not all of them will be saved by similar settlements.

Your account could potentially be facing a debit balance as of tomorrow.

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