Just 16% of the pension plans and endowments that were interviewed for a recent Greenwich Associates’ survey, How Institutional Investors Use and Think About Exchange-Listed Options, are considering investing in exchange-listed options or increasing their allocation to them, compared with 48% of money managers. “It appears that the use of listed options has come in and out of favor over time,” said Tim Barron, senior vice president, chief investment officer, Segal Marco Advisors, an advisory firm. Just 3% of pension funds are considering using or increasing their allocation to over-the-counter (OTC) options versus 38% of money managers, the survey found.
Interest in option strategies typically increase post crisis periods, “as fear takes over from greed and investors seek protection post a melt-down,” Barron said. “Interest also increases from some investors as bull markets get long in the teeth as investors seek to protect from a possible melt down. In both cases, the question of when you act is a pretty important determinant of effectiveness, and therein lies the reason that there has not been widespread adoption: A highly variable experience that is investor and timing dependent,” he said.
The risks often associated with options are dependent on how they are being implemented in a portfolio, according to the report’s author, Richard Johnson, v.p., market structure and technology, at Greenwich. “Some investors think it doesn’t fit with their primary investment strategy, but there are many different types out there; you can have options on T bills or on Indexes, you just have to find one that sticks with your overall investment strategy,” Johnson said. In fact, some of the risk factors typically associated with these tools may simply be perceived risk, he said. “It depends how you use them. They can be risk producing or risk reducing.” They can also be revenue producing.
Barron concurs. “Derivatives of any sort, even listed, give pause to many investors, particularly due to somewhat of a reputation for being a form of leverage associated with risk. In fact, many options based strategies can be applied as risk reducers or as ways to enhance return, particularly by moderating tail risk,” he said.
The seemingly tepid investor interest may also be due to a combination of a lack of familiarity with the products along with outdated mandates that bar some pension funds from investing in these instruments, which are still perceived in some quarters as risky, Johnson said.
The Greenwich study did not provide data on how many public pension plans overall invest in options, but Johnson suggests that it’s a minority of funds, due to individual plan’s investment policy statements (IPS) or stated guidelines and restrictions.
Johnson also suggests that compliance departments should take a hard look at the value these products could provide to a plan’s portfolio, and possibly rescind or reverse mandates against investing in them. “Legacy mandates can be 10 or 20 years old and not a reflection on the latest news,” he said. In the meantime, many investment officers’ hands are tied when it comes to giving options a try.
Some investors think it doesn’t fit with their primary investment strategy, but there are many different types out there; you can have options on T bills or on Indexes, you just have to find one that sticks with your overall investment strategy.
Joseph Cusick, director of institutional investor education at the Options Industry Council (OIC), which commissioned the report, also blames outdated IPS’s. “The guides for establishing pension investment decisions have not been reviewed and updated. These outdated policies are a roadblock,” he said.
The OIC does not have hard data on how many pension funds have mandates that bar them from investing in OTC options or exchange-listed options but “what we do know, from the 80 entities that were surveyed, once a group started the process of looking into and implementing option strategies [the] time to market for 73% of the respondents was less than one year,” Cusick said.
Lack of Education
The other speed bump that may be stalling use of options strategies “is a lack of education and lack of real-world quantitative research, in terms pensions can understand,” said Cusick. Paul R. T. Johnson Jr., a trustee of The State Universities Retirement System of Illinois (SURS), finds this notion particularly unnerving. “The people (trustees) who approve these strategies have little or no knowledge of how these investments work,” he said. SURS of Illinois does use options in its portfolio to both hedge risk and produce revenue and is looking to increase its usage.
Trustee Johnson also cites fear on the part of some investment officers as a reason for the lack of options being used at public pension plans. “If you use them and make lots of money you won’t get a raise, and if something bad happens, you could lose your job,” he noted. “So, what’s the incentive?”
But change may be afoot. “With the advent of so many strategies that utilize some form of derivatives, this is changing. Time and education have created greater comfort as well,” Barron said.
Many of the pension plans that continue to be underfunded today could be using exchange-listed options as a way to help reduce risk and provide protections and risk-adjusted returns, according to Cusick. “Since 2008, pension funds have been trying to claw back from the fall we had, when they were all down on average 22%. But since then we have seen an unprecedented bull market, so they should be looking at different offerings,” Cusick stated.
He adds that while many pension funds are looking to add alternatives to their investment portfolios, they are still mostly taping illiquid credit and private equity, compared to private asset managers who have a much broader reach when it comes to alternative investments.
Thirty six percent of the respondents to the Greenwich survey are public pension plans, 27% are corporate pension plans, 23% are asset managers and 14% are endowments. Measured by assets under management (AUM), 30% percent of respondent have over $50 billion, 30% have $2-10 billion, 26% have under $2 billion, 9% have $26 to $50 billion and 5% have $11 to 25 billion.
Eighty U.S. investors were interviewed for the Greenwich report. Total AUM for the funds captured in the survey was more than $1 trillion.