As risk has dialed up in today's uncertain climate, there has been a growing trend of mutual funds embracing the flexibility and creativity of various options strategies to dampen volatility and garner better returns.

Options strategies are increasingly accessed in the liquid form of a mutual fund, emerging for investors as that ideal alternative investment to add to a typical asset allocation. These strategies are popular solutions to those veering away from the traditional 60/40 model that has become increasingly outdated. Each options strategy produces a unique set of rewards, seeking a better risk-adjusted return as an alternative equity product.

Some mutual fund firms write covered call options to generate income and others use options strategies to limit market risk, while some utilize shorting strategies. Among mutual fund firms, there are a number worth noting for innovative use of options strategies, ones that illustrate some of the most effective ways to confront today's low yield and volatile investment landscape.

Van Hulzen Asset Management advises a fund that seeks to reduce volatility and dependence on the equity markets for favorable returns by deploying a signature covered call investment strategy. It uses options to reduce volatility while still maintaining a large equity directional exposure. The idea is to create a portfolio with less volatility than the S and P 500 Index and other equity market indices.

The fund invests in large-cap companies that have a history of paying regular dividends, have produced strong returns on investment, have below-average debt and a consistent track record of creating shareholder value.

Swan Wealth Advisors manages a fund that represents more of a hedged equity strategy with the objective of capturing long-term absolute returns in any economic environment. With this market-neutral fund, seek positive returns and downside protection, embracing an investment process that buys index put options in an attempt to protect the fund from severe market declines. It sells index call and put options on the full equity and hedge portfolio. That creates cash flow from premiums, serving as a stabilizing element to the portfolio.

The philosophy of this strategy, created in 1997, is based on research that indicates that market timing and/or stock selection is very difficult. It also adheres to the belief that asset allocation is limited in its ability to reduce risk.

Another fund, advised by Absolute Investment Management, is based on the role of financial bubbles in the economy. Their macro view considers that, prior to 2008, the economy was boosted by a set of four interacting bubbles--those of the housing, consumer spending, private debt and stock market.

When the housing bubble popped, the remaining three bubbles came down, and the government responded by inflating the government debt bubble and the dollar bubble. Those two served as airbags to block the fall of the economy. The fund anticipates an "aftershock" if the government debt and dollar bubbles pop, bringing down the four other bubbles with them.

The fund operates on the premise that "pumping up" the economy might work in the short term, but not the long term, and there are profits to be made when that downturn strikes. In other words, "bubble money" will ultimately disappear because it's not based on fundamental economic growth, but rather on financial manipulation or intervention in the form of printed money or massive amounts of borrowed money.

That means, for example, the fund might hedge its gold exchange-traded funds with puts--using options in its portfolios to deal with the short term realities versus what it believes the "aftershock" will be in the long term. That is, although the long term opportunities with gold might be more attractive than the short term ones, those short term opportunities can be best captured with the help of puts to limit the risk.

Options now play a significant role in leading to a broader diversified portfolio and a way to potentially capture better returns in down markets. They are becoming a larger portion of portfolios as a result of investors' inability to handle the volatility of equities because of the 30-year bull-run on fixed income. More and more advisors are adding options strategies to their client portfolios as a core allocation.

Unlike stock, which needs to go up in value for investors to benefit, an options position can be constructed to benefit the investor without a rise in value. The investor could benefit even if the stock sits still, meaning they allow for more opportunity for potential profit.

In the worst case scenario, another big market downturn could lead to investors becoming so frustrated with the losses that they don't want to invest anymore, feeling raw from the exposure to equities and potentially fixed income. This is where options strategies fill a crucial niche. Diversification now comes in the form of strategy, as opposed to market capitalization, and they play nicely into that trend.

While they can be complex, options strategies can serve as an ideal tool to help mutual fund investors retain a better grip on their investments and survive even the worst of market downturns.

Andrew Rogers is Chief Executive Officer of Gemini Fund Services, LLC.

 

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