That’s especially true at a pension fund. CalPERS tries to generate an annual return of 7% on its investments, leaving little room for error at a time when risk-free rates are close to zero. This kind of bear-market hedge can cost $5 million a year for every $1 billion protected, according to Dean Curnutt, chief executive officer of Macro Risk Advisors, which devises risk-management strategies for institutional investors.

“It becomes hard to establish and hold these hedges because they eat away at precious returns,” Curnutt said. “Pension funds have return targets that are highly unrealistic.”

Seeking Protection

CalPERS, based in Sacramento, manages about $350 billion to fund the retirement benefits for some 2 million state employees, from firefighters to librarians to garbage collectors. When the pension plan doesn’t meet its 7% target, taxpayers may have to kick in more money to make sure there’s enough to meet its long-term obligations.

Half of CalPERS’s assets are in stocks, and historically it has tried to blunt the impact of market downturns by investing in bonds, real estate, private equity and hedge funds. Over the past 20 years, the portfolio has returned 5.8% annually, compared with 5.9% for the S&P 500 and about 4.6% for an index of Treasuries.

In 2016, Ted Eliopoulos, then CalPERS’s chief investment officer, asked his staff to investigate ways of protecting its stock holdings from crashes such as those in 1987, 2001 and 2008, according to the people familiar with the fund. He’d been inspired by Nassim Taleb, the former options trader who wrote about the probabilities of rare but devastating events in his 2007 bestseller “The Black Swan.”

The year after the book was published, Lehman Brothers went bankrupt, stocks imploded and the global economy seized up. CalPERS reported a 23% loss in 12 months, and Taleb became a celebrity.

Rare Events
Tail-risk hedging evolved from probability theory. In statistics, the fat belly of a bell curve represents events that are likeliest to occur while the skinny tail ends indicate those that are possible but infrequent, such as a collapse in financial markets.

In 2017, CalPERS hired two outside fund managers to provide tail-risk protection. Universa Investments, a Miami-based firm advised by Taleb, provided the potentially more profitable hedge; LongTail Alpha in Newport Beach, California, the second one.

The investments, initially small and exploratory, quadrupled in size over the following two years. They ultimately safeguarded the pension plan against losses on several billion dollars, the people familiar with the situation said.