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Protecting equity gains with options

At the 10-year anniversary of the longest bull market in history for US equities, the S&P 500 Index has delivered 400% in total returns over the past decade. Many pension plans have benefited from rising equity markets and may now want to protect these gains.

At the 10-year anniversary of the longest bull market in history for US equities, the S&P 500 Index has delivered 400% in total returns over the past decade. Many pension plans have benefited from rising equity markets and may now want to protect these gains.

At the recent Pensioen Pro Congress in the Netherlands, Koye Somefun, Head Of Multi Asset & Solutions in the Quant Research Group at BNP Paribas Asset Management, presented a strategy to protect equity gains with options. In this article, he explains why these strategies make sense for Dutch pension funds in the current environment.

It’s not just the perception of a high cost that makes pension funds hesitant to implement equity protection strategies with options. The timing of the deployment of put options and the loss of potential recovery power also cause doubts.

These misgivings became apparent at the congress during a workshop I gave on how pension funds can hedge their equity holdings against a stock market crash. [1]

The main risk: equity portfolio losses

In my view, the greatest investment risk pension funds currently face concerns their equity portfolio.

In theory, interest rate risk is the greatest danger, but in practice, it is largely covered. For most pension funds, however, equity risk is completely unhedged.

Since the S&P 500 has now more than overcome the losses sustained during the Great Financial Crisis (see exhibit), this is not a problem in itself. Investors who opted for an equity protection strategy with options in recent years have actually achieved lower returns.

protecting equity gains

The question now is whether a pension fund can withstand large losses in the short term. In the event of a major sell-off, intervention by the central bank – as the industry supervisor – cannot be excluded.

The prudent option: protection

In my opinion, it may be prudent to put in place a temporary protection strategy with options. This can achieved with, for example, futures, put options or a combination of put and call options.

With an options strategy, the return on the S&P 500 from 2004 to 2018 was lower than without protection, but the underperformance during sell-offs was also smaller.

Currently, pension fund clients in the Netherlands do not use such protection strategies. This contrasts with insurance companies and pension funds in, for example, Germany and Italy, which actively hedge equity risk with options and/or futures.

At BNP Paribas Asset Management, we believe that option strategies are particularly suitable for Dutch pension funds because the regulator acknowledges they contribute to reducing equity risk.

Keeping the costs down and timing it right

During the workshop, it became clear that various Dutch pension fund managers have considered implementing a protection strategy for their equity portfolio. Ultimately, however, they decided against it for various reasons. It was not just the perceived high cost of put options.

Participants also noted that timing such strategies is difficult. "If we had bought put options in 2016 because of concerns over Brexit and the election of Trump, it would have cost us a lot of return”, remarked one manager. Rather than falling, stock markets have risen further since then.

Adam Barszczowski, board member at the pension fund for physiotherapists, pointed out that an equity protection strategy leads to lower return expectations for equities. This is a difficult subject for his pension fund because it has a funding ratio of around 100%. "We need the full upside potential of equities to be able to maintain the fund’s recovery power."

Pensioenfonds PGB has said that it considers an equity protection strategy to be compatible with its role as a long-term investor.

Appealing options to contain the costs

In the current environment, I believe protecting equity gains with options is well worth considering. Funds with a funding ratio of more than 105% will want to prevent it from falling below that level. A protection barrier for equities can help with this. Additionally, a pension fund would not necessarily need to finance all of this protection by giving away some equity upside.

A well-constructed protection strategy can significantly reduce the costs. Additionally, pension funds could look inside their multi-asset portfolios at other trade-offs. For example, partly financing the equity protecting by (asymmetrically) increasing their interest rate hedge via swaptions (an option on an interest rate swap) could be an interesting alternative. It means less upside in the case that interest rates rise, but more exposure to rising equity markets.

[1] ‘Winter is coming’. How do you prepare your portfolio for winter? Spring is almost here, but according to many analysts, the prospects are particularly harsh. Some are quoting ‘Game of Thrones’: ‘Winter is coming’. How can managers best prepare their pension funds?; Pensioen Pro Congress workshop on 14 March 2019

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