Options: To Use or Not to Use

Terry Flanagan

For pensions and other institutional investors, the choice to use options is a pro/con trade-off.

A pension considering options should monitor the market’s level of pricing risk and understand what liquidity is available, and where, according to Terry Dennison, senior partner and U.S. director of consulting at consultancy Mercer. The price of an option is especially sensitive to the expectations of the market’s direction.

“Volatility is up, so the VIX (Volatility Index) goes up — there are constant gyrations between fear and greed, and that impacts the cost of protection,” Dennison said.

As with any new strategy, a pension who wants to trade options typically first calls on its consultants for feedback, according to Phil Gocke of Options Industry Council. Some market participants have said this is the main roadblock, i.e. the consultant recommends against using options.

Jay Strohmaier of The Clifton Group said pension plans’ chief investment officers have historically been more receptive towards introducing options into a portfolio, compared with consultants and trustees; however, that divergence in opinion has been narrowing.

“With many expecting less robust capital market returns and elevated volatility in the years ahead, more investors are coming around to the idea that well-crafted options strategies may be able to make helpful contributions to protecting capital in downdrafts, and can also be used to help generate important incremental income in the future,” Strohmaier said.

Public pension plans tend to take a more conservative view on options compared with corporate plans and endowments and foundations, which generally have more expertise regarding options and are not as rule-bound. But beyond a plan’s type or size, Gocke said a willingness to get started with an options program most frequently comes from the investment committee, whose expertise and openness varies by plan. Pensioners themselves are also having their say.

“The representatives of the actual pensioners are increasingly interested in becoming more aware about various investment options,” Gocke said. “There are groups that put on weekly (or) quarterly investment symposiums to help educate these trustees.”

In addition to the OIC, consultants such as Mercer as well as the media or ‘trade press’ serve as educational vehicles for the options space, according to Dennison.

Pensions that have reportedly added buy-write options strategies over the past few years include the Santa Barbara County Employees Retirement System, the Hawaii Employees Retirement System, the Los Angeles Department of Water and Power Employees Retirement Plan, the Seattle City Employee Retirement System and the Alaska Retirement Management Board. The options strategies are benchmarked against the Chicago Board Options Exchange’s BXM index.

For Gocke, one measure of options’ popularity is the number of options-specific money managers. “In the last two or three years I have noticed an increase in money managers that use options strategies in their portfolios designed for pension plans,” Gocke said. “Typically, pension-plan sponsors are asset allocators and are not going to execute these strategies themselves.”

More than one third of institutional managers expect to expand their use of equity derivatives this year, and 45% of institutions will use options more, according to a 2011 survey conducted by Greenwich Associates. Most of the other respondents said their use of derivatives and options would hold steady.

Options themselves have become more complex and represent more underlying asset classes. But for a pension plan first venturing into the options realm, straightforward equity options are the most likely choice.

“Pension funds are using mainly equity options because it is within the equity markets that we see the most risk,” Dennison said. “Exposure to equity risk premium represents pervasive and substantial risks.”

“There is a high component of equity risk premium associated with high yield bonds and private equity…which is a just a different flavor of equity,” he continued.  “Hedge funds are also usually made of bonds and stocks; they’re just managed in a nonconventional way.”

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