California Pension Fund Manager Catches On to Options To Plug Gaps; Covered Call Writing Boosts Returns 50%

tradersmagazine logo  Courtesy of Peter Chapman

MarketsMuse Editor Note: This is a late post; the original article was published Mar 21. Given the use of options as a means to enhance returns for pension funds has remained ridiculously under-explored by fiduciaries since listed options were introduced 4 decades ago, now that public pension plans are struggling, perhaps Sacramento will prove to be a pioneer.

For the past 18 months, the City of Sacramento has been writing covered calls and buying the occasional put. It trades options primarily to enhance its yield, but also to preserve principal.

John Colville is the city’s portfolio manager. “A big objective of our portfolio is fixed-income interest and dividend payments,” Colville explained. “We needed to augment that. And you can’t do it in bonds or the stock market.”

Colville manages about $300 million of the city’s $2 billion in pension assets. Of that, about $135 million is invested in equities. The rest is comprised of fixed-income securities.

Of that $135 million in equities, Colville writes calls against $70 million to $90 million during any given month. He uses a mixture of options on indexes, exchange-traded funds, and individual stocks.

The decision to incorporate options into his investment strategy was not taken lightly. Most pension plans abhor options because they are not well understood and conjure up images of gambling. But a yawning gap between the plan’s assets and liabilities gave Colville’s investment board the courage it needed to take the plunge.

Based on data provided by Colville, in the 18 months from July 2011 to December 2012, Sacramento’s options program proved successful. The yield in its large portfolio jumped 50 percent, from 2 percent to 3.2 percent, as a result. The yield on its international portfolio more than doubled to 4.8 percent

Sacramento’s policy only permits the fund to sell calls or buy puts against existing positions. Only basic strategies. No call spreads. No put spreads. Nothing more complex. The heart of Sacramento’s strategy is writing calls against its existing positions. Writing calls against stocks you hold brings in premium income on the contracts and reduces losses in declining markets. But it also truncates gains, when the prices of the covered securities move up past the strike price.

The money manager, who joined the city in 1994 after a stint at CalSTRS, can only trade options against 30 percent of the portfolio and must restrict himself to contracts of 90 days or less.

Colville typically writes out-of-the-money calls that have no more than 30 to 40 days to go before expiration. To reduce the risk that a stock will be called away, Colville typically allows for about 5 percent appreciation in the stock. “How often is the market going to rise 5 percent in a given month?” he asked rhetorically.

“Sometimes I trip over myself and think I’m smarter than the market,” he admitted. The money manager pays his institutional options broker about 50 to 75 basis points in fees annually to manage the program and handle the trades.

Other metrics show the money manager’s use of options both reduced his portfolio’s risk and allowed him to outperform a similar portfolio that did not incorporate options.

“These are impressive numbers,” said the options brokerage executive responsible for the firm’s derivatives business. “Granted, it’s only about $100 million, but it’s still significant.”

“We’re probably in the first or second inning of this,” he said. “But the pension fund world is starting to realize they need to add yield.”