DENVER - Although only a few public pension plans have embraced covered call selling as an investment strategy to date, one pension fund executive said selling covered calls has allowed his fund to maintain a much higher allocation to equities than the average public pension fund, with about the same amount of risk.
"It's like having your cake and eating it, too," said Norman G. Benedict, deputy executive director for investments at the $31 billion Colorado Public Employees' Retirement Association. "I don't know why everyone's not doing it."
The "cake" in this case is Colorado's covered call strategy, a hedging strategy designed to limit the downside risk of holding equities by selling calls against those equity holdings.
The fund has close to 80% of its assets in equities. That compares with an average equity allocation of around 65% for the largest public pension funds, according to Pensions & Investments' annual plan sponsor survey. Yet Colorado's relatively high equity exposure has not translated into more risk, Mr. Benedict said, thanks to its hedging strategy.
Selling calls written against underlying securities the fund owns either outright or through index strategies has lowered Colorado's risk to the same level as a pension fund with less money in equities, Mr. Benedict said, while providing better returns.
That's because selling calls buys the fund protection when stock prices fall. The sale of a covered call option also brings in a premium that is based on the price of the stock at the time of the call and the strike price of the call. As an example, a pension fund that owns 100 shares of a company that's trading at $50 per share would hedge against a possible decline in the stock price by writing and selling a call set to expire in a couple of months at a strike price of $55 per share. The price of the call, or the premium, is $2.75 per share.
Downside protection
By writing and selling the call, the pension fund has bought itself 23/4 points of downside protection through the premium. In other words, the stock can fall to $47.25 per share at the time the call expires before the pension fund will start to lose money. If the stock closes above the $55 strike price at expiration, the fund can either let the stock be called away at the strike price or buy back the call option at a loss. If it lets the stock be called away, it realizes a profit of $500 on the stock sale plus the $275 premium. If it buys back the option at a loss, that loss will be overshadowed by the increase in the price of the underlying security.
Additionally, the pension fund can roll its calls either up or down at expiration, depending on where it thinks the underlying stock price is headed. Rolling involves buying back the original calls and selling new ones to either partake of a bigger upside or buy more downside protection.
Colorado writes calls on stocks it owns through its Standard & Poor's 500 stock index portfolio. Maturities vary between three and six months.
The strategy has been a success for Colorado, Mr. Benedict said. The fund's five-year annualized return through Dec. 31 was 13.5% with a standard deviation of 5. In addition, Mr. Benedict said, the fund has taken in $500 million in premiums since adopting the strategy in the mid-1990s.
Colorado's higher annualized return might stand to reason, given the plan's greater dedication to equities, which historically have provided better returns than fixed income. But having the same standard deviation as that of a plan with 10% to 15% less of its assets allocated to equities seems counterintuitive, given that equities also are historically more volatile than fixed income.
"The whole thrust is twofold," Mr. Benedict said. "We reduce the volatility of our portfolio and we receive income when we sell these covered calls, which also benefits the portfolio. Second, it allows us to increase our equity exposure and still maintain the median risk when compared with other pension funds."
Colorado's consultant, William M. Mercer Investment Consulting Inc., Los Angeles, recommended the covered call strategy. Terry Dennison, a principal with Mercer who works with the Colorado fund, said selling covered calls isn't a popular strategy. In fact, Colorado is the only client he has that uses it, and no other clients have asked about it.
"It's a very client-specific situation," he said.
Upside limits
The obvious drawback to covered calls in recent years has been the limit they impose on participation in upside gains. Mr. Dennison said the strategy is used only in the context of a portfolio structure in which the value it adds is greater than its cost.
Mr. Benedict said Colorado compensated for giving up some upside performance over the past few years by increasing its allocation to equities.
Colorado sells covered calls only on its $18 billion in domestic equity investments. Two-thirds of that amount is in an S&P 500 stock index fund, Mr. Benedict said. The remainder is in passive portfolios that are quantitatively managed and in one actively managed portfolio. Selling the covered calls on the index portfolios turns them into enhanced index portfolios.
Rampart Investment Management, Boston, manages the fund's covered call strategy. Ronald M. Egalka, Rampart president and chief executive officer, said although his firm hasn't seen a big increase in the number of clients using covered call options, he has been answering more questions about the strategy from pension funds.
Rampart uses a quantitative approach to managing its hedging strategies. The firm offers an enhanced index strategy and a yield enhancement program that works like an overlay strategy, Mr. Egalka said.
Colorado uses both. The enhanced index strategy uses put and call spreads to generate 100 to 200 basis points of incremental return, regardless of the direction of the market, Mr. Egalka said. The yield enhancement program uses equity options written on the underlying portfolio, which provides incremental return and reduces risk.
"We believe that individual stocks should have options written against them at all times," he said. "The amount of each stock's individual hedge can be and is a function of the difference between today's stock price and the ultimate price or target price at which all stocks should be fully hedged."
Rampart's computers wash a fund's portfolio through a series of calculations that determine how much of any particular stock should be hedged. As an example, for a stock trading today at $50 with a target price of $100, Rampart will start by writing calls against 10% to 12% of the stock portfolio. As the stock price climbs, Rampart will buy back the lower strike price calls at expiration and roll them into higher strike price calls, each time incorporating more of the underlying stock.
Likewise, if the stock price falls, the computer will roll into a smaller number of calls using less of the underlying stock, Mr. Egalka said.
Ohio, Wisconsin considering
The $54 billion Ohio Public Employees' Retirement System, Columbus, and the $65 billion State of Wisconsin Investment Board, Madison, both are looking at the strategy.
Ohio used covered calls years ago but stopped in the early 1990s, said Dan Sarver, head of domestic equity. The fund is in the midst of a comprehensive investment review, scheduled to conclude by the end of the year. It will look at covered call options and other derivative strategies.
He said covered calls can add value but pointed out that in addition to losing out on potential upside gain, it also is difficult to find people knowledgeable enough to run the strategy.
Joseph Gorman, chief investment officer for equities at the Wisconsin fund, said officials there have looked at covered call selling but haven't yet made any decisions .
"We're looking for as big a lift as we can out of the volatility that's there (in the markets)," he said. "Probably the main reason it (covered calls) never went forward before was nobody fell in love with the idea and carried it forward."
