The booming U.S. equity market is creating headaches for options overwriting managers, with one measure showing overwriting losses of almost 9% for the first three quarters of the year.
As a result, some pension executives are seeing portions of their equity returns being reduced by as much as one-third or greater, and now may show negative returns for the life of their options programs.
Some pension fund executives - including Detroit Edison Co., San Diego City Employees' Retirement, and the Shelby County Retirement System - are sticking with options overwriting, recognizing this year's strong equity returns are highly unusual. But others, such as the Wayne County Employees' Retirement System and the District of Columbia Retirement Board, have dropped their programs.
(Generally, an option overlay program involves selling call options against holdings in a fund. Selling a call confers the right to buy securities, or a basket of securities, at a particular price from the seller).
The Ryan Index, run by S.W. Ryan & Co., a Bala Cynwyd, Pa.-based brokerage firm and consultant, shows the average, non-dollar-weighted options overwriter return to be -8.88% for the first nine months of 1995. (The index is currently composed of 10 managers who provide their returns on a quarterly basis to S.W. Ryan). The Standard & Poor's 500 Index, meanwhile, is up 29.8% for the same period.
The depth of the losses taken by managers this year is unusual. Since the Ryan index was started in 1987, the greatest one-year loss in options overwriting was -4.7%, in 1991.
Allen Anning, director-trust fund management for Detroit Edison, Detroit, said Detroit Edison's program is probably negative overall. The utility's $1.2 billion fund lost more than fund executives would have expected, he said.
"This will take awhile to recover the losses of '95," he said, but Detroit Edison is sticking with it.
Mr. Anning said losses are expected from options overwriting strategies when the market is as strong as it has been. "Good news for the portfolio (is) bad news for our hedging strategies," he said.
Detroit Edison has employed Loomis, Sayles & Co. since 1989 and Oppenheimer Capital since 1990. The two firms each write options against $100 million, which combined represent about 40% of the plan's domestic equity portfolio, he said.
Doug McCalla, investment officer with the $1.48 billion San Diego City Employees' Retirement System, said the system's now-$500 million options overlay program probably has given back 200 to 300 basis points of overall equity returns since its inception in February 1993.
But the losses taken this year are expected given the equity market environment, and fund executives don't plan on altering the program, he said.
Mr. McCalla said the fund went from a gain of $4 million to $5 million on the program to having to pay out $9 million in closing positions this year as a result of the booming market. The system has had one manager, Loomis Sayles, since the program was consolidated this summer. Analytic Investment Management Inc., Irvine, Calif. previously ran half the program.
He said Analytic was let go because San Diego City's officials originally hired two managers for some investment style diversity, but weren't really getting it. The change didn't reduce the size of the program, he said.
David Pontius, manager of pension investments for the Shelby County Retirement System, Memphis, Tenn., said the fund's experience with options writing has been pretty good, given the market's strong move upward. While the fund gives up some upside return in the stocks it owns during sharply rising markets, its risk-adjusted returns still look pretty good, he said.
Others, though, may have been caught off-guard by the size of gains being returned by options programs, said Janet Becker-Wold, vice president in the Denver office of Callan Associates Inc. "Most plans sort of looked at it as gravy," she said.
Losses would have been buffeted by the fact that most sponsors do not place overlays over the entire equity program, she said.
Last July, the Wayne County System ended its $200 million options overwriting program after it started losing money, said Joseph Magda, executive director of the Detroit-based system. The program had "eroded whatever we had picked up since '92," when the program was started, he said.
Market conditions don't warrant using an options overwriting program right now, he said. Loomis Sayles managed Wayne County's program.
Also this summer, the District of Columbia Retirement Board, Washington, terminated its options overlay program run by Loomis Sayles. At the time, Jeanna Cullins, executive director, said: "We believe that the incremental returns we were supposed to get had not been realized." The program had been in place for six years, and overlaid $600 million in pension assets.
Another public pension executive, who declined to be identified, said his fund ended its options overwriting program when it started losing money.
"The board decided that it doesn't make sense to be unhappy in times of joy," he said. While the program had a very small effect on the whole portfolio - it overlaid 25% of its equities - it ended up being a net loser for the life of the program, he said.
William T. Mullen, a managing partner at Loomis Sayles, runs options program over more than $5 billion worth of U.S. and non-U.S. equities. He said that now is the wrong time to end an options program, after the market has spiked upward.
He said Loomis' program has had only one other down year. He said that while the program is down this year - Loomis' performance was -5.5% the first three quarters - in the long term the program will make money.
Options writing programs can vary widely in strategy. Loomis uses index options, and doesn't try to time the market, Mr. Mullen said. That means it will write options consistently as equity prices rise and fall.
One downside to writing options on indexes is that, because they're generally settled in cash, the writer may have to pay up if they are exercised, Ms. Becker-Wold of Callan said.
When writing against individual securities, no cash is paid out, but the writer loses the underlying security, resulting in the same net effect: the loss of potential stock market gain.
Jay Strohmaier, vice president with The Clifton Group, Minneapolis, said his firm's options overlay strategy is flat for the year, because it hasn't written a single call option. The Clifton Group's strategy is to sell call options when strategists think options prices are high relative to their normal pricing. (A put or call option's price will vary depending on the market's expectation of volatility in the market. If expected volatility is high, put and call option prices generally will be higher, and vice versa).
Like Loomis, Clifton doesn't try to time when the market is going to rise or fall.