Updated 3 May 2020, 4 May 2020, 18 May 2020
AIMCo’s board and management are facing troubling questions about how it has conducted its investment management strategy.
In 2016, the Institute for Public Economics published a paper I wrote that examined the success of the corporatization project. Prior to 2008, Alberta Investment Management, a division of the province’s Finance department, provided investment management services to provincial public sector pension plans, to provincial agencies, and to the provincial government. The paper was a preliminary assessment on how the new organization delivered on the promise made by previous Finance Ministers: namely, the organization would deliver returns in excess of those achieved by the previous governmental organization.
My conclusions were tentative since AIMCo’s track record was only about five years and AIMCo inherited portfolios from its predecessor organization. In addition, AIMCo commenced operations during the Global Financial Crisis. However, by comparing the performance of AIMCo with agreed benchmarks set by each of the pension funds, AIMCo’s performance relative to its predecessor, did not demonstrate that AIMCo was a superior manager. What was apparent: salaries of executives, in particular, but all staff, increased significantly. So too did the costs to the plans rise, which was anticipated. Nevertheless clients were not enthralled with the achievements of AIMCo relative to the benchmark. When compared with other pension fund organizations like Ontario Teachers or the Canada Pension Plan Investment Board, AIMCo was essentially middle of the pack at best.
The study offered some criticisms which remain relevant today. First, the directors of AIMCo owe their duty to the corporation and not to the beneficiaries of the plans AIMCo is managing. This should be changed to ensure the directors also take into consideration the interests of the pensioners and contributors. Second, the board members could only be “blue-chip” corporate directors which was supposed to improve results but did not appear to do so. (The NDP changed the Regulation in 2017 to remove the “blue-chip” element. In practice, the selection choices remained limited to the small pool of corporate directors.)
In an unpublished study (2017) I wrote showed that AIMCo’s Alberta directors were large donors to the Progressive Conservative Association of Alberta, personally or through their companies.
Another key recommendation of the 2016 study was to eliminate the requirement that AIMCo have a de facto monopoly on managing pension funds. This measure was also brought in by the NDP in 2018-19, but this change was reversed in Bill 22. The study proposed a full examination of the market-based compensation incentives be carried out. The paper concluded a public review of the Corporation’s investment performance and governance be undertaken.
Troubles
There is a lot that can go wrong in provincial agencies that manage billions of dollars. Recent reports from The Globe and Mail and Progress Alberta show that a potential $5 billion hit to Heritage Fund and pension fund asset values may have occurred over the past several months and years.
Institutional Investor‘s Leanna Orr broke the story on 21 April entitled “Aimco’s $3 Billion Volatility Trading Blunder.” The story contains damaging details of how highly complex investment strategies which might have a “minus-infinity potential,” according to one quantitative hedge fund manager who “frequently trades with the likes of AIMCo.” Orr also reported “AIMCo’s derivative-based “portable alpha” overlays — may have exacerbated the bleeding, according to one of the sources.”
The New York-based investment media outlet also noted that only a handful of institutional investors run their own “volatility trading strategies in house,” with the vast majority of them Canadian. Orr added that David Triska, a portfolio manager at AIMCo, claimed credit in a Linked-In profile for the complex trading program.
The complexity of these investment strategies are reflected in arcane historical and mathematical relationship including “historical options data, volatility surface estimation, and methodology inspired by at least three types of stochastic volatility.”
The Globe and Mail article reported AIMCo entered a contract or “volatility-related investment strategy,” based on an exchange of payments between AIMCo (on behalf of its pension funds and, possibly the Heritage Fund) and a counterparty, normally a large foreign owned bank or asset manager. Under this strategy, when equity markets are volatile AIMCo would pay the counterparty; if equity market conditions were placid, AIMCo would receive payments. Regrettably, market conditions in February and March of this year caused the derivative contract to move into an extreme payment (“out-of-the money”) position.
AIMCo CEO Kevin Uebelein disputes some of the news reports. In a public message on 30 April he stated he was “accountable for the performance” of AIMCo, and felt “responsible for setting the record straight.” Uebelein explained that the extent of losses “to date are approximately $2.1 billion of the $118.8 billion of assets managed on behalf of our clients.” The final tally of losses “will not be finalized until the strategy is completely wound down, which should occur by mid-June.”
AIMCo’s CEO stressed the unusual magnitude of equity price volatility, noting the importance of portfolio diversification. While AIMCo may have its own views on asset allocation and diversification strategies, the boards of the pension plan actually set the strategic asset allocation.
Uebelein went on saying “AIMCo takes full responsibility for the investment losses incurred by this strategy.” Further, “AIMCo’s Board and Management share the frustration and disappointment of our clients, their beneficiaries, and all Albertans.”
To reassure Albertans, beneficiaries and clients, Uebelein announced that AIMCo’s Board has initiated a “thorough review of the situation” using “AIMCo’s internal audit capabilities…and outside, third party experts.” There was no mention in the letter about Progress Alberta’s report which suggested there could be up to $1.1 billion in potential losses lurking in the books of pension funds and the Heritage Fund. Uebelein concluded: “I am fully focussed on one thing: making any and all changes to ensure AIMCo is stronger and that we avoid a repeat of this outcome, regardless of market turmoil” (emphasis added).
This statement “regardless of market turmoil” is a very high bar to satisfy and begs the question who is responsible and what are the consequences of not meeting this high bar. For example, does AIMCo’s value-added incentive system have a clawback provision when returns are significantly lower than the set benchmarks, notwithstanding market turbulence?
Government silence
To date, the government minister responsible for AIMCo, Treasury Board President, Travis Toews (pictured) has not said anything. AIMCo spokesman, Denes Nemeth, acknowledged to the Toronto newspaper, “extreme market volatility” and observed that no “internal or external rules or regulations related to the risk it can take on as a fund manager acting on behalf of pensioners and government accounts,” were breached.
On Thursday, 24 April, Jessica Goodwin, a spokesperson for Finance Minister Toews advised National Post reporter columnist Barbara Shecter that AIMCo would be doing a “review and providing updates to the Minister.”
In the case of the Progress Alberta report, a disturbing series of investments of the Alberta Growth Mandate into oil and gas firms have proven to be ill -timed. Not only are Alberta taxpayers going to lose ten of millions in these Heritage Fund investments, but public sector plans have also bought portions of these ill-fated investments.
As previously reported in Abpolecon.ca, these mostly energy and real estate investments are high risk and have done little to diversify Alberta’s economy, in spite of diversification being a key policy feature of the announced program.
Some questions
Economic theory offers an interesting perspective on the relationship between “Principals” and “Agents.” Principals hold the real power and money, while Agents are tasked with carrying out the mandate of the principal. AIMCo is an agent of the Alberta Crown and therefore the liabilities it assumes become those of the principal and similarly the assets of AIMCo are also those of the Principal or the Crown. The Principal-Agent “problem” is: how does the Principal – Crown or pension fund- oversee the activities of its agent. For instance, the risks the Agent takes, subject to any written instructions, are ultimately the risks of the Principal, and in the case of pension funds, the pensioner and contributor..
Indemnification
Under section 3(2) of the Act,
(2) an action or other legal proceeding in respect of a right or obligation acquired or incurred by the Corporation on behalf of the Crown in right of Alberta, whether in the name of the Corporation or in the name of the Crown in right of Alberta, may be brought or taken by or against the Corporation in the name of the Corporation.
This curious wording seems to imply that in the final event, recourse in repaying litigation awards would be first to the corporation. In disputes which arise involving this investment strategy presumably the directors and officers will be made whole under the Regulation.
The usual provision of indemnities not applying when there has been negligence is strangely missing under the AIMCo Act and Regulation. For example, the ATB Financial Act permits ATB to indemnify directors and officers so long as that “person acted honestly, in good faith and with a view to the best interests of ATB Financial.” Section 24(2), which defines the Duty of Care of an ATB directors, states when considering “a particular transaction or course of action is in the best interests of ATB Financial, a director or officer shall have due regard to the interests of the Crown in right of Alberta and the depositors of ATB Financial.” No such clause appears in the AIMCo Act or Regulation- a clear shortcoming.
Section 12 of the AIMCo Act, outlines the nature of the indemnification which will be important reading for directors, officers, pension fund directors, and government lawyers over the next few months.
Culture
How an investment manager views risk is central in any understanding of culture of an investment organization. The assumption of risk in a principal-agent relationship runs a continuum from risk averse to risk “hungry”. In understanding where AIMCo sits on this continuum, compensation structures are central.
AIMCo’s compensation structure is based on how AIMCo, not its pension fund clients determine “value-added” by the investment managers. AIMCo’s board selects specific benchmark indices and determines how much value was added by the corporation’s investment mangers. These particular measures may not incent the desired investment performance for the assets of 31 clients managed by AIMCo.
AIMCo’s complex reward structure is asymmetric meaning AIMCo staff aren’t penalized too much for losses, but there is a huge upside when value is added irrespective of risk.
Some Questions
First and foremost, did AIMCo supervisory staff, including the Chief Investment Officer and risk management staff understand the investment strategy put in place, notably the “minus-infinity potential outcomes?”
According to Leo Kolivakis at Pension Pulse “AIMCo’s CIO Dale MacMaster a few times and he’s definitely one of the sharpest CIOs I ever spoken to (trust me, I’ve spoken to the very best hedge fund managers, if Dale was remotely incompetent, I’d sniff it out in a second).”
Were investment clients able to make choices that could have avoided their involvement in complex investment strategies?
What information was provided to the investment, credit committees of executive management and related committees of the AIMCo board concerning this investment strategy?
Did such a strategy require the review and approval of these AIMCo committees or could such a strategy be approved without a committee review? If such a review took place, is there a record of the questions addressed to the portfolio managers by supervisory staff or Board committee members?
What was the process for monitoring and reporting within AIMCo when the value at risk of the contract was increasingly “out of the money”? For instance, were there stop-loss or trip wires that required supervisory management to sign off on carrying on with these contracts?
More generally, was the question ever asked if this was an appropriate exposure for pension plan clients?
Which institution or institutions entered into these equity volatility strategies as AIMCo’s counter-parties? How many transactions were entered into, and what is the ratio between the notional value of the contracts and the value of the initial investment?
When and what information was provided to the boards or managers at the various pension funds about the investment strategy and inherent risks?
Does the AIMCo board have any fiduciary role to play over the public pension funds that AIMCo manages? If the board members have only their annual and board meeting stipends at stake, are pensioners and contributors really getting good governance?
When was the Minister of Finance advised of these losses? Further, what has the Minister done to investigate the dual tragedies of the Alberta Growth Mandate and the massive investment bet gone wrong?
Who is accountable for the incentive plan for AIMCo officers and employees? Is the Minister or his senior officials provided the description and rationale for AIMCo’s incentive-based incentive system?
All these types of questions could be asked of both the Alberta Growth Mandate losses and the volatility related investment strategy.
Final Thoughts
First, all pension funds are likely to have a terrific first quarter performance as international equity markets collapsed under the twin weight of COVID-19 and oil price war. Media, analysts and politicians should not jump to quick conclusions about the extent or causes of these troubles. That said, it is incumbent upon the key decision-makers, including AIMCo’s board and pension fund boards to answer questions about these complex transactions. As some policy analysts say “sunlight is the best disinfectant.”
When the United Conservative Party ran for office, there were no policies related to public sector pension funds. Yet once in office, they have launched a concerted campaign to centralize investment management within AIMCo. Where did this policy advice come from? Given AIMCo’s recent track record, it appears that a full, independent appraisal of the culture, oversight and effectiveness of AIMCo’s corporatization is long overdue.
The proposed board review is completely inadequate to meet the concerns of public pension fund contributors and pensioners and Alberta taxpayers. A full review of the corporatization project is called for to assess whether AIMCo’s creation serves the interests of pensioners, contributors, or the interests a small group of employees, board members, and executives. Such a review would be lead by a senior jurist, an academic, and union and employer representation. These individuals should be scrutinized by the Ethics Commissioner to ensure there are no conflicts with AIMCo, compensation consultants, and the investment community.
Interested readers should also take a look at the report from Leo Kolivakis of Pension Pulse for further comment around AIMCo’s investment strategies.
Postscript
On 14 May, the Board of Directors of AIMCo released a statement describing what the Board was doing to review the losses. The Board expressed “deep regret” at the losses and were determined to “prevent .. similar occurrences,” echoing a similar pledge from AIMCo’s CEO.
The comprehensive review of the volatility trading strategy however is far too narrow to determine what has gone wrong at AIMCo. While KPMG LLP and Barbara Zvan, the former Chief Risk Officer of Ontario Teachers’ Pension Plan, are estimable reviewers, the apparent remit is too narrow. Not only have these disclosed losses raised critical questions about risk management, still a number of other systemic issues remain. These include the culture of AIMCo as it has evolved from a division in the Finance department to a 500 person organization. What are the values followed in the organization? How do individual managers regard their fiduciary obligations to their clients? Has the compensation structure contributed to a difference in approach to risk management? Should the Board of Directors owe a duty of care to pensioners and members, rather than to AIMCo and AIMCo’s senior management.
In addition, the disclosure of the investments made by AIMCo on behalf of their clients is lacking. Individual pension plan reports fail to show the breakdown of individual investments such as Trident or other members in the Alberta Growth Mandate. While the Heritage Fund report does disclose the bigger investments in commercial real estate and equity portfolio, there is no detail on corporate names (like Trident) in the LAPP and other pension plan reports. Do these governance bodies have access to those reports?
And finally, what is the role of the government which has given a monopoly back to AIMCo and will provide directives? How will the government respond to the report from the AIMCo board? Will the report even by made public? The Board’s announcement simply says it will be “shared” with the “shareholder” and AIMCo’s clients. Surely the taxpayers and members and retirees of these funds ought to have an opportunity to read and react to the report.
Disclosure, governance, culture, and compensation: will Albertans get answers to their questions?