Pensions Warm Up to Options SLOWLY05.29.2012
Are options risky, or do they reduce risk?
That is a question investment decision-makers at pension plans have been mulling more frequently. Known historically for comparatively staid, plain-vanilla investing, pensions have been increasingly deploying options as part of a broader investment strategy, albeit at a gradual pace.
Investors’ perception of options “is definitely changing,” said Phil Gocke, managing director at the Options Industry Council. “There has been a long-held fear of derivatives use, from the perspective that they increase leverage. Today, people are starting to realize options are not weapons of mass destruction, but rather, they can be a highly effective risk-management and yield-enhancement tool.”
Options practitioners, of course, want pension plans and other institutional investors to use options. New users benefit options traders by making markets more liquid, exchanges and broker-dealers stand to gain from the additional order flow, and a broader universe of market participants means more customers for technology providers.
But beyond the self interests of market participants, there is objective evidence that options can allow institutional investors to avert losses. This manifested itself most recently in the 2008-2009 financial crisis, when an effectively deployed options strategy would have protected an equity investor from much of the market’s pain.
Options market participants cite the institutional space as an important, under-penetrated area. Most of the largest pension plans are at least familiar with options and many trade the securities; it’s hit or miss with mid-sized and smaller institutions, many of whom either are barred from trading options via their investment charter, or if they are permitted to trade options they may simply choose not to.
The volume of institutional order flow is what makes pensions and other investment organizations so attractive to options practitioners. Indeed, even a limited options strategy adopted by a mid-sized, $1 billion pension plan can generate more volume than would dozens of active retail-level options traders.
There is ongoing progress in converting mid-sized institutions to options strategies, but the conversion rate is akin to a trickle rather than a torrent, according to market observers. The San Antonio Fire & Police Pension fund recently adopted a covered-call option strategy, one market source said. Executives at the pension fund did not respond to requests for comment.
Pensions typically break down their assets across three asset classes: stocks, bonds, and alternatives, which may include real estate, hedge funds, and private equity. Options and other derivatives may fall under the alternatives category, which is often kept at less than 20% of total assets, Gocke noted.
Aside from the perceived riskiness of options, another reason cited by pension plans for steering clear is that options and their related overlay strategies don’t fit neatly into a standard style-box configuration and would thus have to be labeled miscellaneous.
For pensions that are adopting or expanding options strategies, a prime motivation is to manage tail risk, which arises when an investment moves more than three standard deviations. In other words, if Google stock falls from $650 to $200, does a shareholder have put options in place that would offset most or all of the losses from the stock drop?
Options can manage and reshape risk within a portfolio, according to Jay Strohmaier, senior portfolio manager at The Clifton Group, a derivatives specialist that manages $30 billion on behalf of about 170 institutions including pension plans, health-care plans, foundations, endowments, and Taft-Hartley plans.
“They can be used as a means to add risk, reduce risk and create very customized and asymmetric risk/return profiles that can sometimes better align with the specific risk-management needs of clients,” Strohmaier said.
Still, options require understanding. “The successful integration of an options-based strategy often requires that investors take the time necessary to become better educated on the fundamentals and nuances of options trading,” Strohmaier said. “They have an additional layer of complexity that can be fairly confusing for those who don’t have experience with them, as opposed to stocks and bonds.”
Institutions can manage tail risk via multiple investment vehicles, including market-neutral or short-biased hedge funds, high-quality, conservative stocks, and gold. “These all provide some reduction of the exposure to equity risk premium,” said Terry Dennison, senior partner and U.S. director of consulting at Mercer.
Yet, options are the cleanest tail-risk hedge, according to Dennison. “Buying at-the-money put options is a pure tail-risk hedge, as it provides ‘first-dollar loss’ coverage,” he said, adding that investors can also hedge via more advanced strategies such as buy-put collars, put spreads and put-spread collars.
Aside from protecting against investment losses, options can also be used to ameliorate other risks such as upside risk, and the risk of being underexposed to risky assets vis-à-vis investment mandates.
While put options can directly offset tail risk, they are not without cost – another factor behind institutional reticence to deploy the securities.
“If many market participants believe that the market will decline significantly, the cost of insurance — the option’s premium — can become astronomical,” Dennison said. “Any tail-risk strategy is expensive to maintain continuously, as the options generally expire worthless.”
Dennison said a pension considering options should monitor the market’s level of pricing risk and understand what liquidity is available, and where. 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 Gocke of OIC. Some market participants have said this is the main roadblock, i.e. the consultant is the decision maker most likely to advise against using options.
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 derivatives 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. End users 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 the 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 non-conventional way.”
If direct hedges via put strategies are too costly, pensions can utilize the income-generating technique of writing call options and pocketing the premium as long as the underlying stock doesn’t rise enough for the option to pay off.
“Buy-write strategies have been around forever because it’s a way to seek income from a portfolio, particularly in trendless markets,” Dennison said. A buy-write strategy generated about 5-8% more than a long-U.S. equity strategy in 2011, when stocks were highly volatile yet finished roughly flat, according to Gocke of OIC.
In 2010, pensions’ most utilized options strategy was the collar, a direct strategy for downside protection that entails buying an out-of-the-money put option while simultaneously writing an out-of-the-money call option.
For Strohmaier of The Clifton Group, a holistic approach to managing institutional investment risk needs to go beyond simple hedging.
“While buying put options to hedge downside risk, or buying call options to hedge upside risk are basic, appropriate strategies that most people are familiar with, it makes sense to look beyond the most basic structures in order to create more cost-effective hedging strategies,” Strohmaier said.
Some of these beyond-basic de-risking strategies include put spreads or put-spread collars, “where short option positions are incorporated into a hedge to reduce up-front premium outlays and/or increase the notional hedge size for a given hedging budget,” Strohmaier said.
Other mechanisms include conventional asset allocation changes, along with using short option positions to generate incremental income. Income-generating programs, known as explicit risk-management programs at The Clifton Group, combined with traditional hedging strategies in both cyclical downdrafts and in environments that pose more severe downside risk, make up the most popular exchanges between the firm and its institutional investors.
“On the income-generation side, we manage option overwriting programs where equity-index call options are sold against equity portfolios, or equity-index puts are sold against cash portfolios,” Strohmaier said. “These types of strategies are often managed on an overlay basis where we manage the options without disrupting the underlying securities against which the options are sold.”
The Clifton Group currently manages fully funded low-volatility equity portfolios, which seek attractive risk-adjusted returns by conventionally reducing risk, and selling equity-index put and call options to capitalize on their tendency to “trade rich relative to their theoretical fair pricing.” This is a strategy designed to exchange a portion of the equity-market risk premium, in order to capture the insurance risk premium associated with options.
In the wake of the financial crisis, expected investment returns have been on the decline, and pensions have increasingly turned toward alternatives and away from stocks and bonds in an attempt to clear their investment-return hurdles. A shift toward alternatives may be all a pension plan need to bump up returns, but at the same time, experts warn that alpha generation should be left up to a plan’s non-option allocations.
“If people are using options to seek alpha, they must be aware of the impact of leverage,” said Dennison of Mercer. “Investment policies typically include options with derivatives so that enhanced monitoring ensures they are used appropriately, for hedging rather than speculative purposes.”
Leverage is a major risk that Strohmaier highlights to the firm’s pension clients, in addition to margin collateral risk, which warrants cash collateral to maintain option positions at the start and over time. There is also early-termination risk, which indicates a stop to an existing options program should investments sour.
“Options can be used as a means to reduce portfolio risk, and they can also be used as a means to lever portfolios up,” Strohmaier said. “Like any power tool, they can be used properly to create desirable outcomes, but they can also be abused and create tremendous portfolio havoc.”