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Why an Options Fund Is a Good Idea Now

18 September 2016

If the Beatle’s Nowhere Man was an investor today, he would buy an options fund. For those who don’t have a point of view on the stock market and know not where it’s going to, writing call or put options on their portfolios can help generate income even if the market goes literally nowhere.

Options are derivative contracts giving the purchaser of the option either the right to buy (a call option) or to force you to buy (a put option) securities at a specific price by a specific date. For the purchaser of an option, a call is a hedge that stocks will rise — if so, the buyer of a call will exercise the option and buy your stock at a price that’s lower than its current market value. Puts are, for purchasers, hedges against a falling market—if the price of a stock has fallen, the put buyer can force the seller to buy stock for a price higher than its current value. Mutual funds both purchase and sell, or “write,” options. The seller of an option collects a premium for doing so, regardless whether or not the buyer exercises the option.

Now seems like the time to employ such a strategy. Bonds yield little, investors have dramatically scaled back expectations for stocks, and respected analysts such as Research Affiliates have projected Standard & Poor’s 500 returns over the next decade of just 1.1% after deducting inflation—or about 4% if inflation matches its historical average.

Even if your stock expectations are more generous, an options overlay makes sense. Sean Heron, manager of the Glenmede Secured Options Portfolio (ticker: GTSOX), expects stocks to deliver 7% a year going forward. “We can get the same returns as equities with about two thirds of risk in the current environment,” Heron says. “We should end up with a better risk-adjusted return than any combination of equities and bonds you want to try.” That sounds bold, but the fund has delivered 10.5% annualized over the last five years with 69% of the S&P 500’s volatility.

OPTIONS STRATEGIES VARY significantly, however. This April, Morningstar finally broke options funds into their own category, though Josh Charlson, Morningstar’s director of Alternative Strategies Research, acknowledges “this new category is fairly heterogeneous.” Returns in the Option Writing category have ranged from 15% to -19% in the past year.

There are currently 45 funds in the category, which is split into three groups. One is strict options-writing funds like Glenmede Secured. Another is funds that write call options, then use a portion of the premiums they collect on that to buy put options to hedge against downturns—what is known as an options “collar.” Such is the strategy of the $8.2 billion Gateway fund (GATEX), the largest and oldest options fund.

Collar funds are the most conservative in the category. Gateway lost just 13.9% in 2008, when the S&P 500 was down 37% and the average options fund lost 27.1%. The fund also has an excellent long-term record, having produced a 6.9% annualized return from 1988 through June 2016 with only 39% of the market’s risk—a risk profile more like high-quality bonds than stocks.

But such insurance damps the upside, since put options that expire worthless are a drag on returns in bull markets. For this reason, the Gateway fund has lagged behind its peers in six of the last seven calendar years since the 2008 crash. “Gateway likes to remove as much risk as possible,” says Heron. “My problem is the cost of removing the risk is prohibitively expensive.” Since put options generally trade more expensively than comparable calls—a phenomenon known as skew—why sell a cheap asset to buy a more expensive one, Heron argues. “We like to do the opposite. We’re usually one of the ones selling those expensive puts to Gateway,” he says.

Gateway’s co-manager Mike Buckius acknowledges the skew problem, but says, “We aren’t seeing this environment as one where puts are overpriced.” Historically, the fund pays 2.5% to 5% of assets per annum on average in put-option costs, but currently costs are at the low end of that range, near 2.5%, he says. Then again, according to its latest fact sheet, the fund is earning between 7.5% to 10% on its call options, which are also priced cheaply. “While the call-option premium range is on the low side, so is the put number,” Buckius says. “I wouldn’t say that on that basis, puts are particularly expensive.”

THE THIRD KIND of options fund has more flexibility, allowing a manager to buy or sell puts and calls depending on his or her assessment of the market or individual securities. This strategy requires a leap of faith that the manager can make the right call. (Pun intended.)

That flexibility can be dangerous. The Schooner fund (SCNAX), for instance, has fallen 19% in the past year. Because its managers felt put options were cheap and that a “black swan”-like event was imminent, they leveraged their defensive bet, and the cost of that insurance hurt them.

A more consistent options strategy makes more sense. “We aren’t smart enough to know that in the next three months the market won’t correct 10%,” says Buckius. “I don’t know if anybody is.” But if it goes nowhere, you’ll still make money.


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