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July 1, 2011

Buyside Shuns Options

By Peter Chapman

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  • Buyside Shuns Options

They're too complex. They're too risky. They're too expensive. That's the sentiment among traditional money managers toward options, according to brokers, hedge funds and exchange officials.

Paul Britton

"You tend to think of these people as the most sophisticated in the world, but a huge number of them still think of options as taking on risk as opposed to managing risk," Ed Provost, an executive vice president at the Chicago Board Options Exchange, said at this year's Options Industry Conference.

While options have been embraced by hedge funds, they have largely been shunned by traditional asset managers. A recent joint survey conducted by the Options Industry Council and Pensions & Investments magazine found that 71 percent of pension plans, endowments and foundations do not use options.

Reasons for avoiding options include prohibitions by institutional investment charters, as well as the complexity and risk associated with the derivative, according to the survey. And there's at least one other big stumbling block, said Kevin Murphy, a managing director at Citigroup, in charge of electronic trading of options.

"It's not just a question of expertise," Murphy said at OIC. "Some of the problem is on the operational side-the custodian side. They have these huge portfolios. To write calls against those portfolios is not a simple process to set up. They have to be able to handle those escrow receipts. It involves going back and forth with their clearing brokers."

Proponents of more complex strategies face an even tougher time. Despite the devastation of their portfolios in the 2008 market rout, money managers are reluctant to tap the volatility arbitrage community for help. That's the conclusion of one volatility trader who markets options strategies as insurance against portfolio losses.

"We've probably had 200 meetings with large institutional investors," Paul Britton, founder and chief executive of hedge fund Capstone Holdings Group, said at OIC. "We got two investors."

Capstone manages $1.1 billion in assets, using equities and options among other asset classes to "trade" volatility. That can involve making bets on the differences in the implied volatility of an option and the actual volatility of the option's underlying security.

Of Capstone's $1.1 billion, about $150 million is invested in strategies intended to show a profit when the value of a long-only portfolio declines. These can involve the use of convexity products such as VIX futures and options and variance swaps. It's a niche business, with about $1.5 billion being managed in such strategies industrywide, Britton said.

Britton is looking to take advantage of the current fears over "tail risk," or large downward movements in an institution's portfolio. The buzz over tail risk and black swans, or unforeseen events, has been under way since the 2008 crash, which saw the stock market drop by 21 percent in a week.