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December 1, 2011

Pensions Eye Buy-Writes

Pensions Eye Buy-Writes

By By Peter Chapman

With crisis comes opportunity. That seems to be the message for the options industry as a group of public pension plans moves closer to incorporating options into their portfolios, most for the first time, in an attempt to squeeze out some of the volatility in their stock portfolios.

The Santa Barbara County Employees Retirement System, the Hawaii Employees Retirement System, the Los Angeles Department of Water and Power Employees Retirement Plan, the Seattle City Employee Retirement System and the Alaska Retirement Management Board are all in various stages of adopting buy-write strategies benchmarked against the Chicago Board Options Exchange's BXM index. The total to be hedged by all five plans could reach more than $1 billion.

"This is one of our approaches to dealing with the fact that the markets are much more volatile now than they used to be," said Colin Bebee, an analyst with Portland, Ore.-based Pension Consulting Alliance, a consultancy advising four of the five plans. "Until recently, a buy-write strategy hasn't been very popular with pension plans, so most of the managers we're dealing with are just now entering into it."

A buy-write, or covered call, strategy involves selling calls against a single stock or basket of stocks. The short call position offsets the long stock position, giving the investor a hedge against dips in the market. As such, however, it can also cap any upside in the stock portfolio. In addition to its hedging properties, the tactic can also be used to generate incremental income as the call seller receives the option's premium.

Benchmarking against the CBOE's BXM index is considered a relatively simple and transparent form of covered call writing as it involves selling a listed SPX option against a portfolio of S&P 500 stocks. In the past, the CBOE has funded studies that claim investors using a BXM strategy can come close to matching the performance of the S&P 500 over the long haul with only two-thirds of the volatility.

Buy-writes are part of a broader group of hedging strategies called "overlays" that use various derivatives including options, futures and swaps to hedge stock portfolios.

"We're starting them off with the BXM idea," Bebee said, "because using listed options is very transparent and you only have to deal with one option per month."

These strategies have long been deployed by high-net-worth individuals, foundations and endowments, but less regularly by pension plans. Their popularity tends to surge after market downturns such as the crashes of 1987 and 2000, and then peter out. Money manager Loomis, Sayles & Co. was a big player in the early 1990s in buy-writes for institutions, but as the bull market roared ahead, the business fell by the wayside.

Much of the renewed interest has been generated by the stock market crash of 2008 and the subsequent bouts of volatility. Recently, for instance, as fears have mounted over the European debt crisis, the CBOE's VIX index has moved into the 30 to 35 range, significantly higher than its norm of about 20.

Players in the niche overlay market are reluctant to predict a gusher of new business this time out, but are still optimistic. "Given the volatility of the last three years, we've seen a lot of interest," said Jack Hansen, chief investment officer of the Clifton Group. "Certainly more than four years ago. Still, in the context of all of the searches and changes going on within institutional portfolios, it's a relatively small number."

Clifton is one of a handful of money managers that specializes in overlays. Others are Rampart Investment Management in Boston, which is managing a program for Santa Barbara County; Gateway Investment Advisers, which won the Hawaii Employees mandate; market makers Gargoyle Group; and Capstone Asset Management. The big passive fund managers, Russell and State Street, have also recently entered the space.