Tuesday, January 21, 2020, was a fateful day in American history. News that a resident of Snohomish County, Washington contracted the first known U.S. case of coronavirus sent the country into a financial and political panic. Donald Trump insisted he had the situation “totally under control,” and JP Morgan Chase CEO Jamie Dimon said the market was in a “Goldilocks place,” but Wall Street wasn’t buying it, and the Dow plunged 152 points.

One company that appeared to take the pandemic seriously was Allianz Global Investors, part of the asset management group for the German mega-firm Allianz, which is — ironically, as it will turn out — the world’s largest insurance company. This is no boutique hedge fund that needs to roll a lot of dice just to make money. Its asset management wing alone claims over $560 billion under management.

On February 3, the company’s chief economist, Mohammed El-Erian, went on CNBC to warn the pandemic was no joke.

“The coronavirus is different,” he said. “It is big. It’s going to paralyze China. It’s going to cascade throughout the global economy. And, importantly, it cannot be countered… by central bank policies.” El-Erian added that investors shouldn’t be cocky and try to game an inevitable rebound. “We should try,” he said, to “resist our inclination to buy the dip.”

If you guessed that Allianz behind the scenes was not resisting but giving in to such temptation, you might be right. In February and March of 2020, several Allianz funds decided to buck conventional wisdom and take a series of unusual positions pegged to the VIX, the Chicago Board of Exchange’s Volatility Index. Three Allianz Funds, which collectively had billions in retiree cash under management, maneuvered themselves to cash in if the VIX went down.

Sometimes called the “fear index,” the VIX looks at the prices of options for S&P 500 companies 30 days into the future. When the expected price variability is high, the VIX goes up, measuring the collective freakout-level of investors. In late February and early March of 2020, the VIX was approaching all-time highs, but the wizards at three Allianz products — the “Alpha 250,” “Alpha 350,” and “Alpha 500” funds — decided to place bets on the VIX going down. As a lawsuit against the company would later assert, the Allianz funds were essentially shorting volatility, in the middle of a devastating global pandemic.

Observers of this case I spoke with last week struggled to find metaphors that would capture the lunacy of the Allianz strategy. The closest analog might be something like selling flood insurance door-to-door as a hurricane barrels toward the coastline. You might make a buck or two if the storm doesn’t hit. But if it does?

Why would a staid, supposedly risk-averse financial conglomerate, one that had marketed itself to investors like the Arkansas Teacher Retirement System as exactly the place to be during “a severe downside market move, such as the Black Monday of 1987,” take such a longshot bet? Why would a fund that insisted, in writing, it had been “designed for tail risk protection, not for outperformance potential,” and had been constructed to be a haven “in the event of a market crash,” employ a seemingly opposite strategy? Hold that thought.

The decision by the three Allianz funds to get short volatility in the middle of a crisis predictably backfired. Alpha 250 went down 43% by the end of March, while Alpha 350’s hit was 56%, and Alpha 500 lost 75%.

At the end of that month, Allianz announced it was liquidating two other funds in the Alpha family, Alpha 1000 and Alpha 1000 Plus, causing investors to lose even more confidence in the remaining funds. The cities, states, and private retirees holding Allianz Alpha investments began to panic as the graph-lines representing their would-be returns kept plummeting. On April 6, 2020, the Arkansas Teachers decided to pull the plug and withdraw from Allianz. The Teachers entered 2020 with $1.62 billion invested in the three funds. By April, they claim, they’d lost a staggering $774 million.

They weren’t the only ones. Before the year was out, Allianz was facing nearly a dozen suits from different parties, many of them retirees.

A fund for public workers of the city of Milwaukee sued, claiming to lose $286 million. New York’s Metropolitan Transportation Authority did the same, claiming a 97% loss of their investment. A group of investors led by a Teamsters’ Union sued after a hit of over $1 billion, and a Blue Cross Blue Shield employee benefits committee was part of a group that took Allianz to court after losing a breathtaking $2.9 billion in the space of six weeks. New suits are flowing in regularly, with two more just hitting the news last week.

The company’s response in nearly all these cases was the same. They said in statements, “We will defend ourselves vigorously against these claims,” noting in several cases that the arguments put forward by litigants were “legally and factually flawed.”

Conceding that the losses in some of these cases were “disappointing,” the company said investors were grownups who knew what they were getting into, as they’d been informed that “the Structured Alpha strategy involved risks commensurate with those higher returns.” In other words: you can’t sue an investment advisor for sucking.

Or can you?

“Here’s the thing about hedge funds,” one financial analyst explained to me. “They earn their money on fees for performance. So if they take a big enough loss, there’s basically no way for them to make money. That’s why you’ll sometimes see a fund just close up shop, rather than work for free for three years or whatever.”

The lawsuit led by the Teamsters’ Union explained the dynamic as it pertained to the Allianz Alpha funds:

The Fund’s fee structure also included what AllianzGI referred to as a “cumulative high water mark” feature, which provided that if an investor’s account were to underperform compared to the S&P 500, that investor would not owe any more fees to AllianzGI until the value of that investor’s account returned to, and increased above, its previous “high water mark.”

The Alpha Funds were already underperforming by the end of February, 2020. Crucially, the funds were also doing poorly compared to the S&P 500, falling below targeted benchmarks by between 5%-10%, causing their “high water mark” to recede from view. The complaint in the Teamster suit alleges the Alpha fund managers were looking at being at least a year away from earning fees again:

By early March 2020, the paper losses already incurred by the Fund (though not yet anywhere remotely near the 75% level) meant that it would likely be at least a year before the Fund’s value would bounce back to its previous “high water mark” and allow AllianzGI to collect fees again.

The plaintiffs in these suits all essentially allege the same thing: that the Allianz fund managers, rather than deal with the reality of working for free for any length of time, concocted a lunatic Hail Mary pass not to rescue their clients’ investments, but their own fees. If the crazy options-based strategy worked, great. If not, the fund would likely either liquidate itself, or the clients themselves would pull their investments. A win-win, unless you happened to be the one with your life’s savings invested.

There might have been an additional irony of what Allianz did in February and March of 2020, involving the specific form of the Hail Mary play drawn up. As noted, Allianz is among the world’s largest insurance companies, a firm that has earned many billions over the years through ruthless avoidance of risk and worship of actuarial tables. But in the middle of the pandemic, with virtually every kind of business desperate to hedge risk, the Allianz funds were seemingly doing the opposite of what a penny-pinching insurance company would be expected to do.

The situation is similar to 2008, when another insurance company, AIG, decided to become the global leader in taking book on subprime mortgages as crisis approached. What doomed the firm was a decision by its AIG Financial Products (AIGFP) division to sell credit default swaps — a kind of derivative pseudo-insurance — on $440 billion worth of bonds, many of them pegged to risky subprime mortgages.

The realization by market analysts, government regulators, and especially AIG’s own customers and counter-parties that the company could not afford to cover all of those bets was a critical trigger-point in the 2008 crash.

The Allianz bets were a bit more creative in their craziness than AIGFP’s, but the basic dynamic was the same: a handful of finance pros taking indefensibly reckless positions with other peoples’ money in pursuit of personal compensation.

The Allianz plaintiffs make a series of claims, most arguing that Allianz promised exactly what it did not deliver, telling investors they were “protect[ed] against a market crash,” using a sophisticated hedging strategy that was “uncorrelated” to disruptions in the markets. This is from an Allianz Alpha brochure in 2016:

Most of the suits against Allianz are in their early stages, beginning a long journey through the federal courts in the Southern District of New York. As discovery comes in, we may hear details of how exactly the German giant concocted a trade that left teachers, cops, subway workers, and other non-millionaires holding a very heavy bag. If and when that happens, we’ll let you know.

I reached out to Allianz for this story and they mostly reiterated their public statements. It is worth pointing out that though the phenomenon of hedge fund managers closing up rather than working without fees is not uncommon, it hasn’t been proved in this case. Also, the only Alpha funds Allianz actually closed were the two 1000 funds. Some retirement programs were invested in those funds as well, including a Chicago laborers’ group and a Carpenters’ group that only just filed new suits. In the rest of the cases, the plaintiffs withdrew the money on their own.

Though plaintiff counsel would likely roll their eyes at the fact, it also has to be noted that the fee structure was known to all of these investors. A possible defense is that investors might have guessed that in the event of a fund striking an iceberg, the managers would jump over their investors into lifeboats.

Either way, it’s a terrible story, and just one of many examples of how the pandemic devastated ordinary people, with more than a little help from vultures in the finance world. Sadly, there is a growing list of similar tales. Check the next newsletter for more.