DECATUR, Ill. -- Options volatility management has boosted the returns of Illinois Power Co.'s pension fund since options overlay was added in November.
Illinois Power executives allocated $30 million to an options overlay program managed by First Quadrant, Pasadena, Calif., with the expectation that the program would complement an existing tactical asset allocation one.
While Illinois Power is still early in its use of options overlay, the program added 68 basis points of return in the last two months of 1997, said James M. Waddell, business leader in the investment group overseeing the $450 million Illinois Power pension fund. That return is within the range of expectations for the options program, which is 50 basis points to 75 basis points of added value.
And the program is adding value this year, he said.
The options strategy is expected to perform better in times of low stock market volatility, which is when TAA doesn't typically perform as well, Mr. Waddell said.
Conversely, when markets are volatile, TAA should perform relatively better than the options strategy, he said.
First Quadrant combines long and short positions in put and call equity options, seeking market neutral returns for Illinois Power. (A call option gives the owner the right to purchase a security or basket of securities at a particular price, while a put option gives the owner the right to sell a security or basket of securities at a particular price). The options strategy is designed to be market neutral, meaning directional bets aren't being taken with the options positions.
Instead, First Quadrant's executives are seeking to profit from changes in the market's pricing of options, which is heavily dependent upon market volatility.
Mr. Waddell said First Quadrant uses a low trading volume approach in managing options that is coordinated with its own TAA managers, but is in the end run separately.
Illinois Power executives chose to overlay only half of their $60 million TAA program, in order to develop a comfort zone with the options management.
Eventually, the options program could be expanded to overlay the entire TAA portfolio, which has been managed by First Quadrant since December 1994.
He said the options program was initiated with ease, and could be terminated with ease, if Illinois Power executives so desired.
Moreover, the options program fits within Illinois Power's existing manager agreement with First Quadrant and its board-approved investment guidelines. Callan Associates assisted the fund with due diligence on the program.
Mr. Waddell noted in a statement that First Quadrant's TAA management has outperformed its benchmarks, even though the markets haven't favored that style of management.