The Champaign, Illinois–based State Universities Retirement System of Illinois (SURS), with approximately $20 billion in assets under management (AUM), is using an exchange-listed options strategy to hedge what some observers perceive as a U.S. equities market on the cusp of a painful tumble, in order to beat the market. “Some option strategies can trail. But popular strategies like covered calls, ATM [at the money] and OTM [out-of-the-money] and put writing should beat a bear market in equities,” according to SURS Trustee Paul R.T. Johnson Jr. The system is looking to transition up to 50% of its equities—or about $5 billion—over the next year into primarily exchange-traded options, due to the products’ “high liquidity, ability to immediately enter or exit positions, transparent pricing and AA+ counterparty risk of a clearing corporation,” he said.
Johnson, who has been a proponent of the strategy even prior to joining the fund’s board in 2012, claimed options strategies will help the Illinois system “keep up with the market in a fast-moving bull market and outperform in a declining and slow-moving market.” He added that “any good option manager will beat the options benchmark, while active S&P 500 managers can’t say the same. Which is why many have moved to passive investment—especially in Large Cap stocks.”
In February, SURS hired investment consultant Pension Consulting Alliance (PCA), replacing NEPC, to help the system move forward with asset allocation recommendations that included the use of options. The Illinois system began executing the equity/options rebalancing in 2017, under NEPC’s guidance. But, due to internal turmoil and staff shake-ups at the fund and at NEPC, the program did not launch fully.
Chief Investment Officer Douglas Wesley, who has been serving as interim CIO since SURS former CIO Dan Allen’s retirement in August of 2016, is also an advocate of the new strategy. “Because Doug has a strong understanding of options use, and what the lack of use may have cost it—SURS is no longer held back,” Johnson asserted. Wesley has been with SURS for just over 20 years.
“PCA has been a leading advocate of the use of options overlay strategies, having recommended approximately $10 billion of various options mandates since 2010,” according to a spokesperson at the firm. NEPC declined to comment on clients or strategies it employs with them.
Cash overlay/rebalancing strategy
SURS began its cash overlay/rebalancing strategy using futures in 2014 to immediately deploy state funding of $1.5 billion to $2 billion that had originally sat for up to 90 days in a cash account, Johnson recounted. “Sitting in a cash account meant that precious money that was part of Illinois’ annual required contribution went unused, thereby returning a fraction of what it could earn in the equity market,” he said. “Using S&P futures and similar global indices gave SURS immediate equity market exposure and has added millions to the bottom line,” Johnson claimed.
SURS also uses about $400 million in a combination options strategy that replicates rebalancing its portfolio. “This strategy takes advantage of price movement in equity value that is otherwise left to the professional traders to harvest. Simply put, it sells OTM puts and calls to…replicate [the] buy or sell orders it would make if [its] equity portfolio were to be out of balance by 5%,” Johnson explained. “Doing this means that SURS gets paid and takes no extra risk than if it were selling or buying at a price 5% out of the money.”
Johnson noted that other systems have also used this strategy to harvest in excess of hundreds of millions in extra income. “Had SURS been using this strategy over the decades it could have possibly produced an average 0.27% extra income annually, or about $43 million on a $16 billion portfolio plus reinvestment returns,” he speculated.
HAWAII ERS cuts loss in down market
Johnson cites the approximately $17 billion Honolulu-based Employees’ Retirement System of the State of Hawaii’s (HIERS) put selling strategy initiated under its former CIO Vijoy Chattergy, who left the fund in February, as an example of how this strategy could work. “He offers a good example of derivative use,” Johnson said. From Jan 25 to Feb 8, Hawaii was down 6%, while US equities were down 11-12%. For calendar year 2018 through Feb 8 HIERS was down 1% while equities were down around 2%. “You never want to lose money, but if you must lose, lose less,” Johnson said.
You never want to lose money, but if you must lose, lose less.
“The Hawaii options selling program performed well within expectations from 2011 through February 2018, and appears to continue to be doing so,” said Chattergy. “The long-term investment horizon, total portfolio context, and using zero leverage has resulted in equity comparable returns with much less risk. The addition of option selling strategies have dramatically improved Hawaii’s risk-adjusted return profile, making the pension fund’s investment portfolio more stable and less risky, despite the moment in time losses from February 2018,” he said. PCA, also the consultant for the Hawaii ERS, was crucial in implementing the strategy there, Chattergy noted.
In February, SURS voted to replace $400 million in funds of hedge funds with hedged strategies using equity-listed options. “The [$200 million] FoHF replacement will be put writing, using S&P, while the [$200 million] global combination strategy will use stock indices around the world,” Johnson said.
Going forward, “SURS will be adjusting its asset allocation under PCA guidance. So, these recently deployed strategies may just be moved into our equity replacement silo or elsewhere, as we proceed into the fall,” he said. For now, “it is still in the works with PCA, staff and board collaboration helping us to move conservatively and pragmatically,” Johnson said.
HOOPP hitches hopes to derivatives
Johnson also pointed to performance of the $77.8 billion in net assets Healthcare of Ontario Pension Plan (HOOPP), last year, as an example of the success this type of equity-replacement strategy can yield. “The fund’s 10-year annualized return is 9.55% and its 20-year annualized return is 9.01%,” according to a spokesperson for the plan. “A good U.S. fund like SURS has a 5.4% return average over the last decade,” Johnson noted. “Everyone should be asking why they aren’t doing as well, what have they missed, and what has HOOPP gotten right?” he emphasized. “The answer is using highly liquid exchange traded tools and the private equity world more prudently,” he advised. HOOPP often uses derivatives and option strategies to gain broad exposure to equity markets, according to a spokesperson at the plan. Exposure to individual stocks is achieved through a combination of cash equity holdings and derivative instruments, she said.
Given his druthers, Johnson would move all of SURS’ domestic equity positions into equity-listed options or derivatives that may include passive ETFs or futures products. He asserted that by doing so, the system could potentially become solvent over the next decade, assuming similar bull and bear markets that have been seen over recent decades. “Simple math says that if we could get most of the 368 basis points better return [like the HOOPP did] in the first year and on average for a decade, Illinois becomes 90% to 100% funded,” Johnson calculated. “That’s decades faster than what is now hoped for,” he lamented. The strategy “also saves an almost quasi-bankrupt state (Illinois) from imploding or raising taxes, which is chasing away tax-paying citizens,” he said.
According to the HOOPP’s 2017 annual report, the plan’s objectives in using derivatives are to enhance returns by facilitating changes in the investment asset mix, to enhance equity and fixed-income portfolio returns, and to manage financial risk. “Derivatives may be used in all of the HOOPP’s permitted asset classes,” the reports states. The plan utilizes foreign exchange forward contracts, futures contracts, options and swaps.
There are many possible outcomes, but use of derivatives markets make it more likely the balance sheet is larger than it would have been without their use.
“These types of strategies are always good, though, like most assets, may at times have negative returns,” according to Johnson. “They will have times of outperforming in most markets and will protect and possibly make money in equity bear markets. If everything goes wrong, you may lose a little less, and if it all goes right you will be way ahead of everyone else,” he said. “There are many possible outcomes, but use of derivatives markets make it more likely the balance sheet is larger than it would have been without their use,” he added.
Derivatives can be easily used in a sideways to slightly up or down market, according to Johnson. “OTM call selling adds revenue as does OTM put selling—all while your equities go nowhere. A hundred million [in revenue] here and a hundred million there, and you have billions down the road,” he said.
And if markets go up? “Many strategies will still make money. Derivatives such as long S&P ETFs will keep up with stockholders. January 2018 was an example of an extremely fast upward moving market. All it did was prompt me to add At the Money covered calls to my portfolio in late January 2018. Put sellers still made money, but less than an outright long stockholder,” Johnson said. “Stocks have caught up during the “Trump” rally into January, and in the short time since, options are coming back,” he added.
Johnson also observed that many pension systems simply look at lowering investment manager fees as a way to increase portfolio revenue. “It’s important, but that’s like getting new windshield wipers for your convertible that has to go up a mountain during a snowstorm. Does it help? Absolutely—to the tune of millions. However, using these options strategies are like new windshield wipers for a four-wheel drive SUV with snow tires. You must navigate the markets better in bad times, so that you can accelerate during the good,” he said.
Johnson believes that many other pension plans are losing out by not embracing an options strategy. Their reason for not doing so, he says, is a lack of education and experience with the products, as well as a lack of initiative on the part of investment officers who fear a backlash—and scathing headlines—if the strategy under performs in the short term.
Johnson’s comfort level in dealing with derivatives comes from his experience in trading and executing these products for decades at the Chicago Board of Trade (CBOT), where, on the exchange’s board of directors, he was also responsible for the writing and maintenance of futures and options contracts. Before joining the SURS-IL Johnson was CIO at LSU Trading, a Chicago-based company Johnson founded to trade equity options, equities, futures and interest rate products.