Options strategy used by pension funds aims to work like a volatility dampener
Some pension funds are seeking to profit from others’ fear.
Pension funds in Hawaii and South Carolina are plying an arcane options strategy called cash-secured put writing. In a typical trade, the investor sells a contract, known as a put, to someone who owns stocks and is willing to pay up for protection in case they decline. If, within a certain time, the shares fall below a given price, the investor buys the stocks at that price, or covers their lost value.
The upside for the pension funds, which are writing options on the S&P 500 index, is that they earn regular income. The strategy aims to work like a volatility dampener. If stocks fall, the income the funds have collected on the options contracts should help cushion any hit they take on the puts and their own separate stockholdings. The pension funds set aside some cash-like instruments such as Treasurys for the payouts, so they aren’t caught without money if the market goes against them.
The cost of options tends to rise when investors expect big market swings, so the strategy does best when investors are fearful and paying up for protection against a downturn—and a downturn doesn’t materialize.
But if protection is cheap and the market takes a big fall, the pension fund can end up with losses.
“There comes a point where you might be picking up pennies in front of a steamroller,” said Nathan Faber, vice president of investment strategies at Newfound Research, an investment manager that uses put writing, but not tied directly to the S&P 500.
For some, the approach offers a way to generate income, which can be especially attractive with government-bond yields at record lows.
Matt Moran, vice president of business development at the Chicago Board Options Exchange, described the put-writing approach in terms of baseball: Over long periods of time, the strategy hits a lot of singles and doubles, but can also hit fewer home runs and hits into fewer double plays than the S&P 500.
The CBOE S&P 500 PutWrite Index, a benchmark for the strategy, has returned 4.4% this year through Friday, versus an 8.4% total return for the S&P 500, which includes dividends. The PutWrite index didn’t fall as sharply as the market during the selloff of early 2016, but has lagged behind the rallies. In 2008, during the financial crisis, the put-write strategy returned minus-27% compared with the S&P 500’s return of minus-37%.
CBOE’s calculations of how the index would have performed before its 2007 creation estimate that annualized returns over the 30 years through this June were 10%, narrowly topping the S&P 500.
Risk mitigation was behind a decision by the Hawaii Employees’ Retirement System to invest $1.6 billion of its $15 billion portfolio in a put-writing strategy, which it expects to be fully invested by October. Based on how the options would have been priced last week, Hawaii could generate about $19 million a month in income if it wrote puts on the full amount and the options weren’t exercised, according to Neil Rue, a managing director at Pension Consulting Alliance, an independent firm that works with the pension fund....MORE