Greenwich Associates has produced research, commissioned by the Options Industry Council, about the way institutional investors understand exchange listed options.
Greenwich concludes that underperforming institutions, including pension plans and endowments, “should be considering investments in options strategies as a means to improve risk-adjusted returns.”
Institutions not currently doing so may be suffering from “governance challenges.” Pensions and endowments have regulatory or compliance constraints, so listed options may fall outside an official mandate.
Greenwish also recommends education and the development of in-house expertise in the field as critical to optimal outcomes.
Altogether: nearly half (48%) of the asset managers surveyed say that they are either considering getting into listed options or that they are already there and are considering increased allocations. As for a disparity in the opposite direction: no asset managers questioned (a fat 0%) are considering insurance-linked investments, which is under consideration (either as a new class or for increased allocation) by 10% of pensions and endowments.
Looking at the difference through a somewhat distinct question: 81% of asset managers have a position in listed options. This is true of only 46% of pensions and endowments.
Listed versus OTC
One alternative to the use of listed options is the use of customized over-the-counter options. An OTC product, Greenwich Associates observes, “may include a combination of listed options and futures, stocks and swaps to gain a specific exposure or payoff.”
But the use of an OTC product involves a lot of complexity, and requires an ISDA Master Agreement, as a bilateral contract between the bank and the institutional investor. Hammering out the terms of this agreement can require several months of negotiation.
So although OTC will continue to play a role, it is unsurprising that listed options represent 71% of total options volume among the surveyed institutions.
Types of Strategies
The report briefly defines the types of options strategy this way: covered calls (the sale of call options on portfolio stocks or ETFs); protective puts (the purchase of put options at or near the money on portfolio stocks or ETFs in order to lock in gains); short puts (the sale of puts on stocks or ETFs where the investor has a favorable opinion, in the expectation of keeping the premium); and collars (the simultaneous purchase of an out of the money put option and sale of an out of the money call — accepting a cap on gains in return for cheap downside protection).
Greenwich says that the institutions within its sample that do use options use all of those strategies. The first two (covered calls and protective puts) are the most popular for this crowd.
The survey also found that index options are very popular with institutions. The reason for this is straightforward: “If an investor is looking for an overall hedge or exposure to market risk, index options are an excellent way to achieve that. The levered nature of options means that a small outlay can achieve a large hedge/exposure.”
From another point of view: index options are subject to section 1256 of the tax code. This means that 60% of the profits of such trading will be taxed at the long-term capital gains rate even if the position is only held for a brief time (less than a year). Stock equity options, and ETF options, on the other hand, that are held for less than a year are taxed at the higher rate for short-term capital gains.
Aside from tax considerations, different sorts of product are suitable for different investor objectives. Options on sector ETFs are becoming more popular over time. Last year, 44% of institutional investors used them. This year that number is up to 48%.
In a sidebar, Greenwich Associates profiles the Employees Retirement System of Texas (ERS) and its use of options.
Funds managed by ERS generally follow a 60/40 allocation between equity positions and fixed income.
The CIO and the head of risk management recently “began … implementing strategies that sought to increase yield from the equity portion of their portfolio, while on the fixed-income side they were used to gain better entry and exit points. Their experience was positive, and they are now in the process of opening margin accounts in order to allocate more capital to the strategies.” All of their downside protection strategies consequently “performed better than the S&P 500 and a traditional 60/40 portfolio during a weak market cycle.”
They told Greenwich Associates that other fund managers hoping to replicate that success should “conduct research, attend conferences, and establish connections within the industry.”