CYPRESS, Calif. -- Officials for the Southern California United Food & Commercial Workers Union & Food Employers pension fund have reduced their U.S. equity market exposure with a $700 million hedge.
The hedge is designed to give the $3.8 billion UFCW fund the stock market's price appreciation, but with no loss of principal by the expiration of the hedge in August of 2001.
While the hedge has been in place just since August, October's market turmoil provided a test for the strategy.
The hedged assets posted a loss of about 1% in October, said Joel Meltz, chief financial officer. By contrast, the Standard & Poor's 500 Stock Index lost 3.34%, including dividends.
Creation of the hedge came as a result of fund officials' desire to lock in some of their huge equity gains.
"We made all this money in the stock market and we didn't want to lose it," Mr. Meltz said.
The hedge combines long call equity index options positions and zero coupon government securities, he said.
Executives at Bank of New York, in New York, were hired as money managers to run the hedge, Mr. Meltz said.
Alex Matturri, head of BONY's special investment products unit, said the UFCW union fund's hedge produces a return that is similar to a structured note that pays a coupon tied to the return of an equity index, such as the S&P 500, and carries a guarantee of principal.
But because the UFCW fund is essentially creating its own structured note, a lot of the fees have been cut from the transaction, Mr. Matturri said.
"You can build it (a structured note) yourself," Mr. Matturri said. "There was a tremendous cost saving passed onto the plan."
The hedge position was created after trustees evaluated alternatives, including a structured note issued by the Federal National Mortgage Association, Washington, Mr. Meltz said.
Trustees decided to purchase zero-coupon U.S. Treasury and agency securities with about three-quarters of the assets, which will have a principal value at the end of the hedge of $700 million. The rest of the proceeds were invested in S&P 500 Index Flex options, which are customized options traded at the Chicago Board Options Exchange. The options will offer the price appreciation of the S&P 500, but not the dividend income.
Exchange-traded options were used for credit-related reasons, Mr. Matturri said.
Bank of New York portfolio managers handled the implementation of the hedge, which included selling securities in the S&P 500 index fund, Mr. Matturri said.
The timing of the hedge was fortuitous because the hedge was put on in August. A combination of lower interest rates and increased stock market volatility since then would have increased the cost of doing the hedge, Mr. Matturri said.
The buying of the calls and the selling of the equities were done in trades that linked the transaction, which furthered the cost savings, he said.
"In a sense, we swapped positions with our broker," Mr. Matturri said.
Otherwise, the broker they selected for the transaction -- Morgan Stanley Dean Witter Discover & Co., New York, -- would have had to hedge not only the call options it was selling to the UFCW, but also the stock positions it was buying.
Using what is called a basis trade, BONY bought the calls and sold the stocks together.
The linked trades were for pieces of the $700 million of equities, with the bulk done over a series of three days.
Bank of New York's role in the hedge transaction differs from that of a broker, because Bank of New York took on fiduciary responsibility as an investment manager, Mr. Matturri said.
"Our main goal is maximizing plan assets and minimizing risk," he said.
Mr. Matturri said the trades were done using techniques Bank of New York developed for performing less specialized tasks, such as aiding portfolio transitions for investors who are hiring or terminating investment managers.
