Options have been used in asset management for several decades, but due to current market conditions asset managers' interest has been renewed in this strategy. With bonds in a bear market and an equity market meandering horizontally, these managers are embracing options as a way to generate income while protecting against the downside.
"The timing of the interest in options is due to the lack of income today," said Craig Van Hulzen, Founder and President of Van Hulzen Asset Management. "You can't get income from bonds and dividend yields are only 2%."
Van Hulzen Asset Management advises the Iron Horse Fund, which utilizes a covered call strategy.
Van Hulzen said in the broader industry options are catching on among consultants, "One other thing we've heard is that consultants are starting to understand the strategy more and seeing how this fits into a traditional asset allocation for them. Even though covered calls are a very straightforward options strategy, people have seen it as an alternative asset class until recently. Some audiences are now looking at it in a more traditional fashion than alternatives."
There are several categories of investors that are likely to be interested in options strategies according to Van Hulzen, "The first is advisor or the investor who feels like the market run--now into its fifth year--is maybe in thefinal stages and that stocks are not necessarily inexpensive any more. They'd like to have some equity exposure, but they want to be careful about just how much exposure. The second class of investor and advisor interested in covered calls are those who used to have allocations to high yield or junk bond categories and some mortgages. Moving away from that space with rising interest rates and some of the price risk and into covered calls is a way to capture the same amount of income, but without the interest rate risk. Both are income driven."
Martin D. Sass, Chairman and Chief Executive Officer of M.D. Sass also points to the bear market in bonds as an opportunity for options-based products. "Looking at the macro picture, we believe that bonds are in a bear market that started last July when the treasury hit 1.39 on the 10 year. We currently view bonds as certificates of confiscation. We are probably in a bear market that will last many years. Investors are faced with potential negative returns that they have already seen so far this year.
"We believe we are still in a bull market in equity. There is need out there for alternative investments that can generate attractive income, have less sensitivity to interest rates and can provide less downside risk and volatility than equities and yet have an opportunity to participate in the upsideof the equity market. We think the strategy that we call Equity Income Plus fits that need."
Sass uses options to generate income and to hedge against downside risk in the firm's Equity Income Plus Fund. "There are three steps to what we do. We buy undervalued stocks with attractive and growing dividend yields. We then sell out of the money covered calls against these stocks and tailor the strategy to the fundamentals of each of the stocks we are long on and we're hedging downside risk with the purchase of out of the money equity index puts. We're also buying index puts," he added.
Sass is seeking a partnership with a strong financial institution with a large distribution capability for this and future funds that will utilize options. "We think this is a strategy that has the ability to grow significantly and meet the needs of retail and institutional investors," he states.
Sass hasn't yet nailed down who the ideal distribution partner would be, he said. "We are still in the early stages. Right now our top priority is the fund we just launched and are doing well with. Though it would be any of an array of firms that have strong mutual fund distribution capabilities. I don't know who that would be right now. In the past we have been very successful partnering with others."
The sky is the limit with the right partner, Sass notes. "We aspire to become a multi-billion dollar mutual fund family some day."
Randy Swan, president of Swan Wealth Advisors runs the Defined Risk Fund, which also uses options to generate income and hedge against risk. Swan's strategy is to buy exchange-traded funds and hedge those with long term put options on the S&P 500. He said that this is in effect buying catastrophic portfolio insurance for clients.
"There are two reasons why a fund like ours is compelling in this environment," Swan noted. "One is the catastrophic loss protection. Why do you insure your health, your wife and your property and not your portfolio? The second is because of the bond situation and the end of the 30-year bull market. We've become an alternative for people who want a more fixed income like structured return in a product that doesn't have interest rate risk. That's where we fit."
Swan said that with these events intermediaries are more willing to consider funds with options. "There is a transformation going on where a lot of advisors and their clients want and are willing to use options. I don't think this has been true historically. That perception that options and derivatives are scary is changing. Clients are demanding it," he states.
Changing technology has made using options easier for asset management companies, Swan added. "One of the reasons we are getting traction is that technology is advancing. Custodians are more willing to support managers like us that use options. A lot still are not, however.
"TD Ameritrade has been a great partner for us. They've allowed us to do things today that five or six years ago were not possible. Options allow a lot more creativity and flexibility, which generate returns. There are literally hundreds of options," said Swan.