With options volume down this year industry professionals are looking beyond traditional players such as retail investors and hedge funds for growth.
“We are strongly focused on the institutional space,” Alan Grigoletto, director of education at the Options Industry Council, said at this year’s joint Futures Industry Association and OIC options conference in New York. “In the coming years, we see much more participation from wealth advisers and pension funds. And even endowments.”
Most of the industry’s volume comes from two sources: retail traders and hedge funds. Retail investors were the driving force that got the industry on its feet in the 1970s. The hedge funds have jumped in over the past 10 years.
But with volume down 13 percent through August of this year, tapping new sources of flow has taken on new urgency. During the first 8 months of this year, volume dropped to an average 16 million contracts per day from 18.5 million last year.
“The appetite is just not there,” Chuck Mack, a Nasdaq OMX managing director, said at the FIA-OIC confab. “We need that appetite. We need the hungry investors to come back in.”
For those looking to corral new players, there’s good news and bad news. The good news is that registered investment advisers are “flocking to the options market,” Jeff Chiappetta, a TD Ameritrade executive responsible for institutional trading, including advisers, told conference go-ers.
The bad news is that pension funds and mutual funds are not flocking to options, according to industry sources. Mutual funds are starting to set up hedged versions of some of their stock funds using options, but the trend is nascent. Pension plans are also tip-toeing into options, but the pace is glacial.
“The trustees on the boards of these [pension] plans come from all walks of life,” Gregg Johnson, a consultant to public pension plans with Gray & Company, told conference attendees. “They range from policemen and firemen up to sophisticated investors. But when they hear the word “options” or “derivatives,” they become frightened. They don’t understand. They always think they add more risk to a portfolio rather than reduce it.”
Johnson’s firm works with public pension plans managing assets of between $100 million to $1 billion. None of them use options, he said.
The former pension actuary finds fault with the entire money management process used by public pension plans. Most trustees “miss the forest for the trees,” he said. They focus too much on the minutiae of asset allocation-tracking managers and benchmarks-rather than the big picture of ensuring their future assets match their future liabilities.
Johnson contends that plan trustees should worry less about the performance of individual managers and more about the risk of the entire portfolio. The issue is one of losing money, not making it, he believes. And to that end, he views options as an essential component in a plan’s investment process.
“I have been surprised by a number of plans that I’ve called that do not use risk management techniques,” Johnson said. “Neither options or anything else.”
While some West Coast pension plans are starting to incorporate options into their investment strategies (See Traders Magazine, December 2011 issue) industry efforts at educating them to the benefits of options face an uphill battle.
Most plans consider themselves to be asset allocators who parcel out portions of their funds to different money managers and don’t consider the portfolio in its entirety.
“In the institutional space,” Phil Gocke, an OIC executive, explained “you’ll rarely find an entity that will buy a put themselves. They’ll allocate to somebody who would do that. But the gross overlay of a portfolio doesn’t really come up.”
Compounding the problem are pension consultants. Considered the “gatekeepers” of pension assets, they have shown little interest in options, say sources. “I don’t know why consultants are reluctant,” Johnson said. “Perhaps it’s too complicated for them.”
In recent years the OIC has geared its educational efforts more towards institutional investors from retail. Grigoletto told attendees that reaching pension plans was not easy. “They’re a tough nut to crack,” Grigoletto said. “It’s very hard. Very opaque.”
Further down the asset management food chain, the picture is brighter. Registered investment advisers, who trade in lots of 100 or 500 contracts or more, are being egged on by their high net worth clients to incorporate options into their strategies.
“They’re hedging positions. They’re generating income. They’re writing covered calls or selling vertical call spreads,” TD Ameritrade’s Chiappetta noted. The executive’s job involves educating advisers about options as well as helping them implement their strategies.
Driving many of them into options are requests from their clients, Chiappetta said. Retail investors in general have become more knowledgeable about options in the past 10 years, he said, and are asking their advisers to incorporate options strategies.
Those strategies are “fairly basic, but sizable,” according to Joanne Draper, a managing director responsible for advisers at Charles Schwab & Co. They include covered calls and buying puts. If advisers do want to utilize more complex strategies, they will likely farm the job out to a separate account or wrap manager, she explained.
Draper credits education as a key factor in making advisers more comfortable with options. “For both retail clients and advisers, once the feel more comfortable with options, they’re more apt to use them,” she said.
Schwab boasts the largest stable of financial advisers. Draper says their options trading is a small, but profitable part of the brokerage’s overall business.
For at least one advisor, most of its options work is farmed out to other managers. “We are cautious users of options,” said John Kemmerer, a director of alternative investment research at Zeke Capital Advisors, which manages about $1.4 billion for 10 family offices. “We don’t use strategies that are heavy users of options, but on the other hand we question the value of a manager that doesn’t use options at all.”
Kemmerer noted that some of his clients are comfortable with options and others aren’t. But everybody on the firm’s investment committee is keen on keeping up with how other managers are using options “in ways they might not be familiar with.”
Zeke likes to stick with “simple strategies,” Kemmerer said, but does avoid downside puts because of the cost. If the manager starts to get worried about a given position, it will sell it and move into cash, rather than pay for protection.
“When we start getting worried about the downside, it’s a signal we need more cash,” he said. “So today, for example, our portfolios are 15 percent in cash.”
Kemmerer emphasizes that this is the policy at the overall portfolio level. Zeke still likes to see its individual managers incorporate hedging with options in their strategies.
In part, the firm uses hedge funds to manage its assets-a group that would not even consider using options 10 years ago. That’s bodes well for the future, Kemmerer said. “Options are moving in the right direction,” he said “Hedge funds are on the cutting edge.”
Despite the momentum coming from the adviser space, at least one options exec is still missing the industry’s oldest client. “Eventually the retail client will come back to us,” Grigoletto told the FIA-OIC crowd. “It’ll be risk-on once again for them. They’ll be using options to the same degree they were using them in the beginning of year.”
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