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Pensions and Endowments Gambled on Market Calm, Then Everything Changed

The Wall Street Journal. logo The Wall Street Journal. 2/14/2018 Gregory Zuckerman, Gunjan Banerji and Heather Gillers

A decade of low bond yields pushed some of the most stability-minded investors to dabble in risky investments that depended on markets being orderly. Now, those bets are looking problematic.

In the past, pension funds, endowments and family offices pursued relatively safe investments. After interest rates collapsed on the heels of the financial crisis, they ran into challenges paying pensioners and filling university budgets, and added riskier bets on hedge funds and venture capital in the hopes of winning better returns.

More recently, some of these investors also made big, unpublicized wagers seeking to benefit from what had been an unusually long period of low volatility, according to pension-fund consultants and others who deal with these intuitions. The strategies, often involving the writing of complicated options contracts, were for years a source of easy money. Markets hadn’t been so calm since the 1950s.

Among those making such bets were Harvard University’s endowment, the Employees’ Retirement System of the State of Hawaii and the Illinois State Universities Retirement System.

Yet volatility has now returned to markets, with a vengeance. When the Dow Jones Industrial Average lost more than 2,400 points in a week, intraday market swings also surged. The Cboe Volatility Index, or VIX, a measure of expected swings in the S&P 500, closed at its highest level last week since August 2015, recording its biggest one-day jump ever on Feb. 5 as it surged to 37.32 from 17.31 the prior day.

The $16.9 billion Hawaii fund in 2016 began earning money selling “put” options—essentially a bet that markets would stay calm or rise. When markets fall, Hawaii is on the hook to pay out.

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“We’ve taken some losses that you’d expect with these sharp moves,” said Vijoy Chattergy, the fund’s chief investment officer, on Feb. 8. He also said “they’re within expectations.”

For now, investors express confidence these strategies will work out. Others in the market, however, worry that any additional turmoil could spur institutions to quit their “low-vol” strategies. “Our fear is when these strategies unwind,” said Alberto Gallo, a portfolio manager at Algebris Investments in London.

Mr. Gallo estimates more than $500 billion of investment strategies globally are dependent on volatility remaining low. These trades include funds that target or sell volatility by using various derivatives.

The rise of low-volatility bets is among the reasons this downturn is different, investors say, and difficult to predict. Some trades are hard to track. It’s also challenging to quantify how much money is in investments betting against volatility or dependent on placid markets. One thing seems certain: with central banks gradually withdrawing their support for the market, the subdued calm of recent years is unlikely to return.

Wagers on low volatility vary by investor. In one popular move, investors bought two exchange-traded products that bet on continued stability for stocks—the ProShares Short VIX Short-Term Futures exchange-traded fund and the VelocityShares Daily Inverse VIX Short-Term exchange-traded note. These were a wager that the key volatility index would fall and stay low.

Together, these funds managed $4 billion until the recent market turbulence, with much of that money coming from the likes of big investors such as Harvard University. Harvard’s endowment, Harvard Management Co., owned over 100,000 shares of the ProShares Short VIX fund as of the end of the third quarter of 2017, filings with the Securities and Exchange Commission show. Its fourth-quarter filing indicate it sold the position, though Harvard’s current holdings are unclear.

“There’s a tsunami of money going into” these types of strategies, said Don Dale, a managing member of consultant Equity Risk Control Group. The firm advises large pension funds and endowments.

Pension funds, endowments and family offices took other steps, including selling VIX futures and options, selling options on the S&P 500 or other indexes and selling options on individual shares or other indexes.

“The low-return environment pushes people into investments they wouldn’t have made eight to 10 years ago,” said David Morehead, Senior Director of Investments at Baylor University’s endowment. “While institutions may not be explicitly trading volatility, more have been pushed into assets with lower quality, higher leverage, and more illiquidity.”

Donald Pierce, the chief investment officer of the $9.3 billion San Bernardino County Employees’ Retirement Association, has been trading volatility for about six years, most recently by buying options on stock indexes, often with trades equivalent to about $300 million of risk for the plan.

Sometimes, Mr. Pierce buys products betting on rising volatility. Other times he sells these products, depending on his view of where U.S., Japanese, Russian, Brazilian and other markets are headed. Mr. Pierce says his trading has saved the county millions recently and that he will continue to make volatility trades.

“We take an opportunistic approach,” he said. “For us, it’s a substitute for equities.”

Other pensions take more one-way bets, including the Hawaii pension system. The put options it began selling in 2016 give holders the right, but not the obligation, to sell stocks at a certain level. When markets are calm, Hawaii receives a check each month from whoever is buying a put option. If markets fall, whoever bought the put can collect.

The fund’s Mr. Chattergy, while worried about an extended downturn, says Hawaii has taken steps to mitigate losses. He said Hawaii will continue to sell these put contracts, convinced the income will offset market turbulence. “We’re continuing to trade the strategy.”

The low-vol trade has worked every year since markets began rebounding in early 2009. Until last Monday, the S&P 500 had enjoyed 404 consecutive trading days without a 5% correction, the longest such streak since September 1959, according to Bianco Research LLC. The average close of the Cboe Volatility Index was 11.09 last year, the lowest average on record going back to 1990.

Many big investors who flocked to these products have been under unique pressures to generate returns. Pension funds across the U.S. typically need to earn 7% to 8% each year to meet obligations. In the past decade, they have struggled to meet that target, while their total assets have fallen as retirement payouts have increased.

As a result, many have lowered their bondholdings and turned to real estate, commodities, hedge funds and private-equity holdings. These so-called alternative investments rose to 26% of holdings at about 150 of the biggest U.S. funds in 2016, compared with 7% more than a decade earlier, according to the Public Plans Database, which is run by a group of nonprofits.

Bondholdings by major public pension plans fell to 21.09% in December 2017 from 25.32% in December 2007, according to Wilshire Trust Universe Comparison Service.

More recently, the army of consulting firms that advise pension funds, such as Wilshire Consulting, has recommended some public-pension-fund clients write put contracts. As recently as 2013, hardly any public pension funds used this strategy, according to Wilshire Consulting President Andrew Junkin. He estimated more than 60 of the nation’s more than 6,000 pension funds now do.

A growing number of Wall Street firms have been selling volatility-related strategies to pension funds and other big investors. Neuberger Berman’s U.S. Equity Index PutWrite Strategy sells puts on stock indexes. Part of the value of a put relates to the volatility of underlying stocks. By selling the puts, the fund aims to generate steady income in stable markets.

In a document prepared for an Illinois pension, the firm argued that behavioral biases in financial markets mean investors “ultimately overpay for protection.” The Neuberger Berman options products have attracted about $3 billion over the past two years.

But the strategy suffers losses when stocks fall. So far this month, the fund has lost 4.37%, through Feb 12, though that tops a loss of 4.52% for its benchmark, a mix of puts on stock indexes and compares with a 5.90% loss for the S&P 500 through that date.

The Neuberger Berman products have outperformed their benchmarks in recent years and the firm notes the price for the puts rises when markets tumble, making the fund a lower-risk way to invest in stocks.

“The efficacy of these strategies manifests itself over months and quarters,” said Doug Kramer, who oversees the strategy at Neuberger. “Everything’s functioning as designed. We’re happy to have higher volatility and be able to underwrite higher option premiums.”

Public pension plans including the Illinois State Universities Retirement System have invested in these products. Illinois SURS declined to be interviewed for this article.

The market’s rebound over the past few days has sparked a new round of investments in some of the riskiest of the volatility trades. The ProShares Short VIX fund, which posted a 97% drop in net asset value last week from its high price in January, has since rebounded—even though volatility indexes such as the one the fund is designed to track can have outsize moves, and likely would see heavy losses and face possible liquidation if volatility spikes again.

On Tuesday, it closed at $11.29, up from a low of $9.58 on Feb. 8, and its market value is now nearly $800 million, up from $300 million just last week.

“People are jumping back into this product again,” said Pav Sethi, chief investment officer of Gladius Capital Management, an investment firm focused on volatility strategies, “despite the clear structural risks.”

Write to Gregory Zuckerman at, Gunjan Banerji at and Heather Gillers at


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