Institutional investors aren't eager to return their unexpected gift from the U.S. stock market: gains of more than 50% in the last year.
As a result, corporate and institutional investors are trying to lock in stock-market gains through derivatives strategies and diversification efforts.
Some corporate executives, such as those at Maytag Corp., are going a step further: studying whether to hedge not only their pension fund but also corporate earnings and cash flow against a market correction.
Bob Bannon, managing director for Analytic TSA Global Asset Management Inc., Los Angeles, said investor interest in hedging against a downturn has picked up: "Everybody thinks the market is topping."
Mr. Bannon said his firm has helped structure collars for clients, but declined to name them.
"The interest over the last month or so, has been a lot (higher)," said Jeffrey Geller, executive director for BEA Associates, New York, in reference to hedging.
Jonathan Muehl, investment consultant for Buck Investment Consulting Inc. in Pittsburgh, said he has assisted pension funds and endowment funds, which he wouldn't name, with the structuring of options-based "collar" strategies. A collar involves buying stock index put options and selling index call options. Generally, the desired effect is protection on the downside, paying for it by selling upside return.
Executives for Maytag are evaluating strategies for hedging its entire corporate exposure to a market downturn, including the use of a collar, said David Urbani, vice president and treasurer of the Newton, Iowa-based company.
But Maytag is seeking to hedge more than just the equity exposure in its roughly $800 million defined benefit plan.
The company is considering ways to hedge the effects of a stock market correction on the entire corporation, such as its cash needs and its corporate earnings, Mr. Urbani said.
The effort is complicated because cash flow and corporate earnings aren't directly correlated to moves in the stock market. Mr. Urbani declined to discuss specifics pending further research.
Mr. Urbani said because Maytag's fund has a big indexed equity exposure, structuring the pension plan exposure's share of the collar would be easier.
Maytag executives expect to make a decision on whether to hedge in mid-September, he said.
But not all investors are convinced derivatives are the proper way to handle a view that the market is high, said Drew Demakis, managing director of research for RogersCasey & Associates, Darien, Conn.
He said that while he has seen an increased curiosity and use of hedging strategies, including the use of derivatives, most of the action has come in the form of broadened diversification strategies.
That would include increased use of international investments, and alternative type of strategies that carry low correlations to the U.S. stock market.
How derivatives are being used in hedging strategies can vary widely, depending on the situation. Children's Health Care in Minneapolis used put options to allow an increased exposure to the stock market in its now $145 million in corporate cash and foundation fund. (Pensions & Investments, Sept. 2, 1996).
Through its hiring of The Clifton Group, Minneapolis, Children's buys put options to create a floor at a level 10% below the market, and funded the long put positions by selling puts at 30% below the market. Effectively, Children's hedge portfolios are protected from a market drop of 10% to 30%.
Susan R. Slocum, director of treasury for Children's, said the strategy has worked out well, allowing the company to earn an extra $2.6 million in equity returns, while costing the fund about 8 basis points in terms of direct cost.
Ms. Slocum said board members have been "quite pleased" with the results, although initially it was a tough sell.
Of course, with the raging bull market, collar strategies implemented in the last couple of years carried big opportunity costs.
In 1995, for actuarial reasons, executives at Armco Inc., Pittsburgh, didn't want its funding level to fall below 90%, and used a combination of caps, collars and other derivatives strategies to prevent that.
"As it turned out, we didn't need the insurance," said Dennis Furey, director of investment management for Armco. Nonetheless, "it accomplished our goals."
Like any form of insurance, one doesn't begrudge the fact you didn't have an accident, he said. With the ascendance of the U.S. stock market, Armco's funding situation has improved dramatically, and it currently doesn't have a need to use hedging strategies, he said.
Mr. Furey said that hedging, in his view, doesn't make sense as a long-term strategy. Collars and puts work well in special situations, such as Armco's, or possibly for temporary rebalancing of assets.
While options managers discourage the use of collars - because of the potential for loss on the upside - investors are attracted to them because up-front costs are minimized.
Current market conditions, where call options are priced relatively high, make collars an attractive option, said Joanne Hill, co-head of equity derivatives research for Goldman, Sachs & Co., New York. Income enhancement strategies, which generally entail selling call options against assets, have fared worse than collars in the bull market, because the seller has lost money in the bull market, and gained nothing in the form of insurance.
Several pension plans have dropped their call overwriting in recent years, including the Philadelphia Municipal Employees' Retirement System and the Wayne County Employees' Retirement System, Detroit.
International interest has picked up as well. Zeneca Group P.L.C., London, recently put a hedging strategy in place in response to new U.K. funding regulations (P&I, Aug. 4).
Other U.K. funds are looking at that as well, brokers and money managers say.