HOUSTON -- Executives at the $16 billion Shell Oil Co. pension fund, which has used futures successfully for seven years, are considering moving into options as well.
Ronald Stapleton, fixed-income director, said he intends to request permission from pension trustees of the Houston-based company to use options. He said "options can be used as a substitute for futures" in some cases, and "you can do a lot of different things with options," some of which he said the fund has not clearly defined yet.
Using futures has helped Mr. Stapleton implement fixed-income portfolio management strategies for the fund and fine-tune the fund's $1.6 billion bond portfolio, to achieve higher returns.
Shell has also joined a small list of firms using a portable alpha strategy. Mr. Stapleton said the strategy "is not a true portable alpha because we don't short anything." It is a more "simplistic" form of portable alpha.
Portable alpha is a strategy pioneered by AMOCO Corp., which is now part of BP Amoco Corp. Mr. Stapleton said he and his associates at Shell are "very aware" of what Chicago-based BP AMOCO is doing with its $13 billion fund and "we know the whole team up there." He added, "we don't do what they do; what we do is a form of it."
Mr. Stapleton said that 40% of Shell's equity portfolio is indexed and he wanted to use the portable alpha strategy "to see if we could add some value over the index."
"We wanted to see if we could create a synthetic Standard & Poor's 500 index fund," by using the strategy, he said.
The fund uses an overlay strategy in which Mr. Stapleton takes the fund's fixed-income portfolio and overlays S&P 500 index contracts on it.
"If you can manage the underlying assets to get a better return than LIBOR," he said, "you should be able to add alpha over the Standard & Poor's 500." The results should equal those of an enhanced S&P index fund.
Mr. Stapleton said that very few funds are using the portable alpha strategy. "It's in its infant stage," he said. "It's slow to catch on because it's a whole different concept."
"Cash markets have become less liquid, making futures markets more attractive" Mr. Stapleton said at the Risk Management Conference held by the Chicago Board of Trade and the Chicago Board Options Exchange last month on Captiva Island, Fla. "If you want to change the duration exposure or yield curve exposure, the best and fastest way to do it is with futures."
In an interview, Mr. Stapleton said, "You can actually adjust the duration of a portfolio depending on the richness or cheapness of futures."
Futures contracts provide a good way to hedge a portfolio of corporate bonds, said Mr. Stapleton, but are not as good for portfolios that combine corporate bonds and mortgages, because those funds will take on more basis risk.
The hedge should be left on for only a short time, he said, "until you can adjust the portfolio in the cash markets. The longer you leave futures on, the more basis risk you have. . . . I want to get the portfolio back to cash if I'm going to be long a strategy."
Futures allow portfolio managers to pay commissions on just the futures trades, rather than paying transaction charges on selling the actual bonds, he said.
Mr. Stapleton said it costs about $16,500 to hedge $100 million worth of 10-year bonds with futures contracts. If the fund were to buy or sell them in the cash markets, the transaction costs would be about $125,000.
Futures can help eliminate unintended yield curve bets and opportunities to increase cash returns through cash/futures arbitrage continue to exist.
Futures also can be used to hedge a portfolio against Federal Reserve interest rate hikes by decreasing exposure to short maturities and increasing exposure to the long end of the yield curve, said Mr. Stapleton.
"If the Fed raises interest rates, eventually the long end of the yield curve will rally," he said.
In order to implement this strategy, a fund would sell a combination of eurodollar contracts and two-year note contracts and buy bond contracts, a strategy Shell has pursued successfully.
Shell has a strategy of always being fully invested and uses futures to "equitize" all pension fund cash. "We look at the amount of cash in our domestic portfolio," he said. "We take that cash and overlay it with a commensurate amount of S&P 500 index contracts. The return should track the S&P 500."