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Funds go exotic with put-write options to stem volatility

Vijoy Chattergy
Vijoy Chattergy said the Hawaii fund uses the strategy to guard against market surprises.

Put-write equity options are finding their way into more pension fund allocations to protect against volatility and, in some cases, take the place of fixed income as an income provider.

The actively managed strategy, which trades on one of 14 exchanges for which Options Clearing Corp., Chicago, serves as the central counterparty, is based on the S&P 500 and other equity indexes. It uses cash-secured puts that, if sold, create immediate income for investors.

The strategy also provides a higher return than more traditional covered-call or buy-write strategies, said Vijoy Chattergy, chief investment officer of the $14.1 billion Hawaii Employees Retirement System, Honolulu.

“The major difference (from covered calls) is that there are larger premiums on the collateralized put-writing side,” said Mr. Chattergy. “This implies things like different risk perceptions, impediments, and investors using puts.”

Hawaii Employees in the spring hired Neuberger Berman, Analytic Investors, UBS Asset Management and Gateway Investment Advisers to run $400 million each in put-write strategies. This was the first move into the strategy for the pension fund.

Earlier this year, the $28.2 billion South Carolina Retirement System Investment Commission, Columbia, hired Russell Implementation Services and AQR Capital Management to each manage $800 million in put-write strategies.

And the $16.6 billion Illinois State Universities Retirement System, Champaign, hired Gladius Capital Management to manage $400 million in notional value in a put-write overlay, a move that Executive Director W. Brian Lewis said would result in “an income enhancement tool.”

Differs from buy-write

Put-write differs from buy-write options, which have been used by pension funds for several years, because of what underlies either option, said Reid Hellekson, senior implementation portfolio manager at Russell in Seattle.

“They're very similar,” Mr. Hellekson said. “Buy-writes have equity holdings underlying the option; put-write has cash underlying the security. Because of this, you get more liquidity from put-write. People use put-write as an equity overlay, replacing their beta one overlay (hedge) with puts.”

The put-write strategy serves both as protection against downside risk and volatility but has the added bonus of providing income, said Frank Tirado, vice president of education, Options Industry Council, Chicago. “This is a strategy that generates income. It does also reduce risk,” Mr. Tirado said.

There's also the advantages of using put-write equity options for both their transparency, because they're traded on exchanges, and for their liquidity, added Matt Moran, vice president, business development, Chicago Board Options Exchange, Chicago. Such options “can be part of a risk-parity strategy and part of a (liability-driven investing) strategy,” as well as an income producer, Mr. Moran said.

The downside of put-write options is if a stock falls below the strike price by expiration, the stock would have to be bought at the original strike price, not at the lower price, and would reflect a loss.

Consultants are starting to take notice, said Mr. Moran, with five of the top 10 firms in terms of assets under advisement writing research papers on put-write options, including the latest issued last month by Wilshire Associates. In its paper, Wilshire noted that the CBOE S&P 500 put-write index, with an annualized 10.1% return, outperformed the CBOE S&P 500 buy-write index's 8.9% and the S&P 500 stock index's 9.9% over 30 years ended Dec. 31. And for 2015 alone, the put-write index returned 6.4% vs. the buy-write index's 5.2% and the S&P 500's 1.4%.

“2016 will be a big year for put-write hiring in terms of RFPs issued and their allocations,” Mr. Moran said.

Mr. Tirado said put-write options are becoming popular with pension funds at a time when their overall equity portfolio can be too risky and their bond portfolio isn't providing enough income in a continuing low-rate environment.

“Pension funds are between a rock and a hard place,” Mr. Tirado said. “Low funding, risky assets, both have exposure to downside risk. In this, they've constructed a strategy to transfer risk.”

Added Mr. Moran: “If stuff does hit the fan and the bubble bursts in bonds — and maybe even equities — there could be even more of a move toward lots of alternative instruments like this, especially when plan trustees start asking their consultants, "Why didn't you tell us about this?'”

Also, a sense of a new normal ahead with low rates and low equity returns has driven interest in the strategy, said Mr. Tirado. “Something like this has never happened before,” he said. “You hold and hope things get better, and with stocks, it has. But what's new is the interest rate situation. Everyone's waited and waited and waited, but it's just not happening. This is new. They don't teach you how to handle negative interest rates when you're in college. Everything is somehow priced to rates, but what if those rates are negative?”

"Defensive equity'

Russell"s Mr. Hellekson said the strategy gives investors “a way to get defensive equity, to reach for carry when the markets are going sideways. That's attractive for some folks.” The carry comes from the cash premium from the put option when sold. “If markets go sideways, they still get income; they can't lose,” he said.

At Hawaii Employees, Mr. Chattergy said the put-writing allocation is a good complement to its call-writing options strategy. “Also, it is a good strategy for our functional risk portfolio allocation structure, within the stabilized growth allocation (and) fits our understanding of how markets work and why a pension plan, as a long-term investor, has an advantage.”

Mr. Chattergy added that unlike other pension funds that are using a put-write strategy as an income source, Hawaii Employees uses it as a way to reduce volatility with the same return as equities.

“The approach and function of put writing that we utilize is valuable in low-rate and high-rate environments,” Mr. Chattergy said. “The challenges of a low-rate fixed-income environment are best addressed in other parts of the portfolio and through plan design ... In the case of HIERS, cash secured put-writing is part of the risk-bearing design; collateralized put-writing is expected to produce the same results as equities with two-thirds the volatility over a full market cycle.” n

This article originally appeared in the October 3, 2016 print issue as, "Funds go exotic to stem volatility".