Updated 21 July 2020
On 9 July AIMCo’s board of directors issued a summary of results of its own review of the “VOLTS investment strategy.” VOLTS stands for Volatility Trading Strategy. The seven page summary report, dated 30 June, was posted on AMICo’s website.
Board’s mandate
Three priorities, set by the Board during its 14 May announcement, were to:
- limit the damage from the volatility trading strategy;
- confirm that no other investment strategies could generate substantial losses in very unusual circumstances; and
- undertake a comprehensive review of the volatility trading strategy to identify lessons learned and corresponding enhancements to AIMCo’s investment and risk management processes….(to) be shared with AIMCo’s clients and shareholder with a target completion of mid-June.”
Except for the release of the Zavn and KPMG reports, the Board was able to state the first two priorities were accomplished.
Input into Summary Report
The Board report relied on input from AIMCo’s Internal Audit department, its Chief Legal Officer (an interesting resource), as well as Barbara Zahn and the senior partners of KPMG’s Financial RIsk Management team. “Separately, AIMCo’s CEO provided the Board with changes he believes are called for” (emphasis added).
Board’s findings
The report’s summary was written for a financially literate reader familiar with words and phrases like: tail risk, variance swap, implied versus actual volatility risk premium, non-linear returns, confidence intervals, value at risk, deep tail risk, volatility term structure risk premium strategy, extreme volatility events. Some or all of the forgoing terms may or may not be familiar to deputy finance ministers or finance ministers and hopefully are familiar to AIMCo’s directors.
The summary seems to absolve the board of responsibility where it states “the Board took action to:
1. mitigate further VOLTS losses and, on management’s recommendation, approve a plan to wind down VOLTS and permanently close the strategy, fixing losses at $2.1 billion.
2. undertake a review of other value-added strategies to identify any with potential for outsized losses. This review confirmed that there were no other strategies with potential for outsized losses akin to VOLTS.
3. launch a comprehensive review of all aspects of VOLTS,determine changes to management processes and governance necessary to prevent any reoccurrence of a similar outcome.”(Page 2)
In receiving input from the Chief Legal Officer and Internal Audit, the Board finds that after commencing a strategy to profit from low volatility in 2013, the investment managers began to expand the program. While the Board report referred to high volatility events like Black Monday in 1987, it failed to remember that the Global Financial Crisis when Lehman went down in September 2008 was only five years before the VOLTS strategy launched.
The first insight from the report is that the “legacy risk system” to measure and monitor risk did not “does not do a good job of assessing risk in a strategy like VOLTS with nonlinear returns, especially when nonlinearity appears largely outside the confidence interval.” While the limitations of the risk management system had been recognized. By January 2020 the Risk Management team had modelled the risks and “called for increased attention to the very low probability but nonetheless extreme tail risk of VOLTS.” Unfortunately by the time March arrived and the Public Equities group began to take action but according to the report “it was too late.”
The “results” of the review suggest that the “first and second line of defence”- investment management (the Chief Investment Officer) and Risk Management (Chief Risk Officer) “was unsatisfactory.” In addition, the Board found that risk governance controls, involving “collaboration and risk culture”was unsatisfactory. Finally the Board found that “escalation of analytics” to senior management and the Board on the extreme tail risk was “incomplete” and tardy.
Some questions
Surely the culture clash between investment portfolio intent on high returns with less concern about risk and risk management professionals is well known inside any financial institution, whether it be a credit granting institution or investment manager. Where was the board in understanding how effective the Chief Executive Officer (CEO) was in settling disputes between the Chief Risk Officer (CRO) and the Chief Investment Officer (CIO)? How effective was the board’s evaluation of this systemic risk to Alberta public servants’ and taxpayers’ assets? In addition, how assertive have been the public sector pension boards in questioning the management of AIMCo over these losses and generally mediocre performance over the past five to ten years? Where is the Minister of Finance in this whole chapter of a play which in the past twelve months has decidedly turned negative for employees in the public and private (WCB) sector and for taxpayers (Heritage Fund)?
Proposed Changes
The Board identified 10 changes that it had adopted since the crisis came to their attention. The first change is that the CEO, CIO, and CRO ensure the “integration” of investment management and risk management staff including movement towards a “more collaborative, inclusive relationship.” But isn’t that the Board and the CEO’s responsibility today?
The second change is a subset of the first- to balance “risk appetite” and “risk tolerance.” Once again, this conflict is legend in financial institution history. Virtually all systemic problems- and AIMCo is by no means an exception- are the result of the dominance of the risk-taking culture over the risk averse culture. The exceptional CEO uses common sense to manage egos and keep the organization on a steady course.
The third suggestion is to get the board more involved in approving “thresholds” involving over-the counter derivative contracts that do not involve “hedging” where one risk is offset by another asset class or strategy. Next the Board wants to be involved at a more “granular” level for risk reporting and “periodic updated stress testing.” The next suggestion is for the development of an “escalation and remediation procedure.. regardless of limit.” Why such procedures and policies were not present is another question for the Board to answer, not management.
Change number six is how the introduction of a new investment strategy or product is managed and monitored. There are six sub-recommendations/changes which read like matters that ideally would have been attended to before this strategy had evolved over the past seven years. These measures include: stress testing; complexity assessment; capacity of Risk Management to measure the risk in the context of the whole portfolio; liquidity of over-the-counter derivative markets; adequacy of staff knowledge; and re-approval of existing strategies under the new, changed framework. Why these policies and procedures were not in place and why the Board apparently did not ask these questions is for the Minister of Finance and each pensioner and contributor to ask the Board and the CEO of AIMCo.
Remaining changes deal with the design of strategies, the Board’s progress in “compensation framework design” and the “Corporation’s talent management strategy,
organizational design and management succession plan.”
The Board report concludes that “a much more stringent set of analysis, review and approval processes,” is required. Overarching is the conclusion that it is not process changes that are needed, “but rather
changes to the culture in which the rules are to be embedded.” The solution: “a more collaborative
environment among risk and investment professionals.”
Further Questions
At the end of the day, the Board has done its job. The $2.1 billion losses, not borne by the well remunerated management or board members, is the result of the failure of whoever is responsible to manage conflicts between risk takers and risk managers. Who is the whoever? Does the Board or Minister of Finance or the CEO and others in AIMCo’s “C-suite” assume any responsibility for these losses? The EVP of Public Equities is gone and so is the manager who was instrumental in this strategy. What will be the consequence on compensation in 2020 for those who played a supporting role in these losses? What would have been the losses taken to the end of March 2020 had AIMCo taken without the VOLT strategy? Presumably the losses would have been materially less.
Opinion
From this observer’s point of view, the Board should never have been investigating itself. This Summary Report affirms the measures taken since the losses were incurred and identifies the causes after the fact. This is the classic circle the wagons strategy. What the Treasury Board President and Minister of Finance must do is appoint a judicial inquiry into why AIMCo’s board and management had not established, before the recent financial meltdown, systems that provided a safe environment for open discussion of the risks being taken. And why did AIMCo management proceed, with or without the Board’s knowledge , proceed with an investment strategy without the risk management system updated before these exotic strategies were adopted? It is time to clear the air before the current government transfers $18 billion of teachers’ school board’s and WCB employers’ contributions to AIMCo.
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