Pension fund executives and their consultants are trying to figure out how to protect their funds' stock-market gains, but they can't come up with a good approach.
Fear of both market timing and derivatives is likely to keep all but a few executives from acting on what instinctively they want to do: hedge some of their huge gains.
The market's runup has led to an exploration of hedging strategies by such pension funds as the Public School Retirement System of Missouri, Jefferson City, and the State of Wisconsin Investment Board, Madison. Both funds took a pass.
For those still studying the issue -- and many are -- the number of available options is limited and the choices aren't very attractive.
Pension executives can:
* Do nothing beyond their normal long-term approach, the classic response;
* Increase asset class diversification, with the expectation that new asset classes won't move in lock-step with the U.S. stock market;
* Use derivatives for downside protection, a generally expensive choice that is not politically correct; or
* Tactically change their asset allocation, also a relatively unpopular choice.
Pension fund officials are worried about the market's high levels and the possibility that gains might be left on the table.
"There's some concern that you should be taking some money off the table, but what are you going to do with it?" said Jac R. Amerell, director of the Milwaukee County Employees' Retirement System. The Milwaukee fund relies on rebalancing, including shifting assets within its broad equity allocation, to capture some of the market's return.
"The biggest concern of plan sponsors is (getting) protection from a market downturn," said Ronald D. Peyton, president and chief executive of Callan Associates Inc., San Francisco.
"Clearly there is an increased level of concern as the market reaches new highs," said John Osborn, a senior consultant for Frank Russell Co., Tacoma, Wash. The growing desire to protect market gains is described as a natural byproduct of the rising stock market.
Stephen Nesbitt, senior vice president and principal for Wilshire Associates Inc., Santa Monica, Calif., advises clients essentially to do nothing by sticking to their long-term plan, no matter how attractive it might be to hedge.
"We don't believe people will systematically make money" from hedging strategies, he said.
He said there are pension funds with specific short-term funding needs that might want to put on some type of hedge, but that is the exception.
Mr. Peyton of Callan said diversification strategies are advocated by Callan executives, and have been adopted over time by many plan sponsors concerned about the stock market's high levels.
By adding allocations to specific sectors of the market, and then rebalancing into them over time, pension funds essentially recapture market gains, he said.
Investors who have had a set allocation to, say, small-capitalization stocks the past few years would have been periodically buying those shares and selling out of gains earned in the large-cap segment, he said.
In addition, other asset classes -- such as international stocks and bonds, real estate, private equities and high-yield bonds -- are being added in hopes they will add diversification to a portfolio.
But even some of these classes can pose their own problems. Kenneth Winston, principal for consultant Richards & Tierney, New York, said pension funds that hedge the currency exposure of their international exposure are losing much of the benefits of diversification in that class.
With the added currency overlay, international equities "becomes a sort of different asset class," he said.
Moreover, in sharp market downturns, "there is a sort of world effect. If the U.S. sneezes, the world catches a cold," Mr. Winston said. Long term, though, international equities should add diversification, he said.
Derivatives generally are a less expensive and quicker alternative to actually selling stock, although buying complete protection against losses in a portfolio can be costly.
While the futures-based strategy called portfolio insurance fell into disrepute during the crash of 1987 when market price gaps prevented strategies from working properly, options are the more popular product today.
Wisconsin explored options-based hedging strategies, but decided against them for now, said Michael McCowin, chief investment officer for the $57 billion fund.
Part of the problem was that small hedges didn't help much, while large hedges would have been difficult to implement.
Moreover, large-scale hedging essentially would have changed the strategy of the fund, and officials decided they could successfully ride the ups and downs of the market, Mr. McCowin said.
At the Missouri Public School fund, officials considered protection strategies about a year ago.
"It's a terribly expensive thing to do," said Mark A. Caplinger, chief investment officer for the $18 billion fund. "We looked at it (hedging) in some detail, and made the conclusion it was cost prohibitive."
Jack Hansen, principal and director of equity investments for derivatives manager The Clifton Group, Minneapolis, said interest in options hedging strategies has picked up, but is not as high as he would expect in such a frothy stock market.
Nevertheless, Clifton has gotten a few assignments, which he declined to identify, he said.
And Clifton has been encouraging the use of long and short put positions, which it calls a re-entry strategy, over the more commonly advocated collars strategy.
A collar entails buying a put option position, and selling a call option position. The long put position, which would give the plan sponsor the right to sell shares at a given price level, generally would rise in value when the market falls.
But puts are expensive, recently costing 3.9% to hedge against a 10% downturn for one year.
Therefore, firms suggest paying for the put by selling a call option.
While the short call position helps cover the cost of the put, or insurance, it also limits upside gains. The short call would rise in value in a rising market, leading to a losing position for the seller of the call.
In the last few years, unusually high returns of U.S. stocks have led "collared" investors to earn less-than-the market returns, Mr. Hansen said.
An alternative to funding the long put with a short call is selling a second put option with a lower strike price than the long put. The short put reduces the cost of the owned put option, and essentially brings the investor back into the stock market at lower price levels.
An investor might protect the portfolio against losses of more than 10%, but not beyond 20%. The position, in effect, sells low and buys lower.
A number of refinements are available to investors interested in the strategy, Mr. Hansen said.
For those inclined to take some action, but wary of using derivative-based strategies, selling stock shares tactically is another option.
In fact, Mr. Osborn of Frank Russell said there are situations where selling stocks and buying bonds creates a similar risk profile to purchasing a put, but with a higher expected return.
Frank Russell consultants encourage clients to consider such temporary shifts -- to say a 25% stocks, 75% bonds allocation -- over put-buying strategies.
Meanwhile, futures-based TAA strategies generally have not proven to be very effective in the 1990s, with TAA's attractiveness "not that great," he said.
In the end, Frank Russell consultants would discourage the use of any market-timing strategies in favor of sticking to a long-term asset allocation decision-making process, Mr. Osborn said.