IRVINE, Calif. - Analytic Investment Management Inc. is working on offering an options overlay strategy that would seek to limit price volatility in a plan sponsor's defined contribution company stock option.
As in existing overlay strategies for defined benefit portfolios, the company stock option overwriting strategy would involve buying and selling put and call options to limit the price risk of owning equities. The difference in Analytic's variation is that it would be managed around the company stock plan.
Analytic's executives suggest plan sponsors offer the strategy around a second company stock option, keeping its primary company stock option intact.
The company stock option with the options overlay would have less risk and could be more diversified depending on the plan sponsor's goals, said Debbie Boedicker, senior vice president of business development and client services.
Employees could participate in the performance of the company's stock, while limiting some of the severe price swings that sometimes occur for reasons unrelated to company performance, Analytic executives say.
Pension consultants, while intrigued with the idea, said the plan would be hard to recommend, given how difficult it would be to explain the strategy to plan participants.
"In theory, I like the idea. In reality and practice, it would be very difficult to implement," because of the educational requirements of a defined contribution plan, said Ruth Hughes-Guden, managing director with Rogers, Casey & Associates Inc., Darien, Conn. While options overlay strategies have been used on the defined benefit side for a while, applying one to the retail-like environment of a defined contribution plan wouldn't be practical, she said.
Echoing Ms. Hughes-Guden's comments, Janie Kass, director, investment consulting services, for Kwasha Lipton, Fort Lee, N.J., said: "I guess I'm a little skeptical" the strategy would work, given the obstacles in explaining options strategies to participants. From a theoretical standpoint, the strategy makes sense, but it might be difficult to get it to work, she said.
Harindra de Silva, director of empirical research for Analytic, said one basic way for the strategy to work would be to buy put options on the company's stock, funding the purchase with the selling of call options. Using that strategy on a fully hedged basis, a company stock option would be limited from a downward price movement of a pre-set amount. (A put option gives the owner the right to sell a security at a given price, while a call option gives the owner the right to buy a security at a given price).
At the same time, Analytic would sell call options, receiving a premium that would be used to pay for the puts.
The sold call options, however, would result in the loss of upside return, Analytic executives say.
Drew Demakis, director of consulting at Rogers Casey, noted the strategy would have a net cost, meaning participants would give up more return on the upside than protection from the downside.
Mr. de Silva acknowledged only certain types of firms could benefit from the strategy. Firms with stocks that are volatile, such as in the technology industry, would be good candidates, he said. The ideal plan sponsor for the strategy would be a company with a stock that is highly volatile, and is optionable.
"It's certainly meant to be a more conservative alternative to a pure company stock plan," Mr. de Silva said.
In addition, a plan sponsor could allow Analytic to buy call options on stock indexes, adding general market gains to the portfolio, even if the company's stock doesn't rise, Ms. Boedicker said.
Analytic's executives see the strategy as a bridge between the conflicting goals of the finance and benefits departments. Executives on the financial side tend to want employees to put company stock into the plan, to support the company's stock price, while benefits personnel tend to want to keep company stock out, to boost investment diversification in the plan. "We see it fulfilling both needs," Mr. de Silva said.
Analytic's executives said the strategy resulted from a client inquiry, and they hope to have money up and running in the strategy by year end.
Mr. Demakis of Rogers Casey noted the strategy "is an interesting attempt to deal with that issue."
Mr. de Silva said the education question would be tackled in the same manner so-called life cycle funds are - explaining the expected risk and reward characteristics of the strategy, without necessarily getting into the mechanics of the call and options strategies. The education efforts with life cycle funds communicate a concept, and have gotten away from what's inside that concept, he said.
Consultants said they were skeptical even under those circumstances a plan sponsor could adequately explain the strategy to participants.
"I think it's an interesting concept, but we're still having a problem getting (participants) away from GICs," said Ms. Kass of Kwasha Lipton. It might be easier just to put less money into a standard company stock option, and more into an equity option, which basically would have the same effect, she said.