Three years ago, America’s largest pension fund made an unusual investment. It bought so-called tail-risk protection, a kind of insurance against financial catastrophe. In a market meltdown like the one sparked by the coronavirus, the strategy promised a massive payout -- more than $1 billion.

If only the California Public Employees Retirement System had stuck with the plan. Instead, CalPERS, as the fund is known, removed one of its two hedges against a bear market just weeks before the viral outbreak sent stocks reeling, according to people familiar with its decision.

The timing couldn’t have been worse. The fund had incurred hundreds of millions of dollars in premium-like costs for those investments. Then it missed out on a bonanza when disaster finally struck.

Softening the blow, CalPERS held on to the second hedge long enough to make several hundred million dollars, one of the people said.

Ben Meng, chief investment officer of CalPERS, said the fund terminated the hedges because they were costly and other risk-management tools are more effective, cheaper and better suited to an asset manager of its size.

“At times like this, we need to strongly resist ‘resulting bias’ -- looking at recent results and then using those results to judge the merits of a decision,” Meng said in a statement. “We are a long-term investor. For the size and complexity of our portfolio, we need to think differently.”

CalPERS had been warned about the perils of shifting strategy. At an August 2019 meeting of its investment committee, Andrew Junkin, then one of the pension plan’s consultants at Wilshire Associates, reviewed the $200 million of tail-risk investments.

“Remember what those are there for,” Junkin told CalPERS executives and board members, according to a transcript. “In normal markets, or in markets that are slightly up or slightly down, or even massively up, those strategies aren’t going to do well. But there could be a day when the market is down significantly, and we come in and we report that the risk-mitigation strategies are up 1,000%.”

Costly Flip-Flop

Sure enough, the position CalPERS gave up generated a 3,600% return in March. The costly flip-flop demonstrates the pitfalls of trying to time stock-market hedging. Like many insurance products, tail-risk protection seems expensive when you need it least.

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