Time might be right to don a collar

For nervous investors who still want equity exposure, puts and calls are a good way to hedge risk

Jan 10, 2010 @ 12:01 am

By Jeff Benjamin

Whether it is to help lock in last year's gains or to put to better use some of the more than $3 trillion parked in money market funds, the creative use of options may be just the tool that finanical advisers need for dealing with skittish investors.

In fact, one time-tested options strategy — “collared” investing, in which options are used to cap upside and downside portfolio swings — is coming back into vogue on the institutional level.

The most recent example involves a partnership between third-party marketing firm Partner Capital Group LLC and alternative-asset manager Gargoyle Investment Advisor LLC.

This month, the two firms will launch an index option overlay strategy that creates customized calls and puts for institutional portfolios of at least $100 million.

“There's an increasing comfort level with the use of options, and after the 2008 Armageddon, more people are looking for ways to protect their unhedged equity investments,” said Jay Easterling, a partner in the overlay services business at Gargoyle, which has been running the collared strategy in a hedge fund format for 10 years.

There are multiple ways to use options to hedge or leverage a portfolio, but a straightforward collar involves writing a call option on an underlying stock while simultaneously buying a put option on the same stock.

By selling call options, investors earn some immediate income in exchange for an agreement to sell the stock at a preset strike price, which limits the original investor's upside return.

Meanwhile, the downside can be protected by purchasing a put option on the same stock. This gives the investor the right to sell the stock at a set strike price, regardless of how low the price drops.

The Gargoyle-Partner Capital overlay strategy, which will charge a 60-basis-point asset-based fee, joins about a dozen other platforms offering option collar strategies for institutional accounts.

So far, the rich opportunities in the institutional market have prevented the option overlay platforms from migrating to the individual-investor level, but that might be the next stage of evolution, according to Mr. Easterling.

“In principle, there's no reason this couldn't be done for retail,” he said.

In the meantime, there are ways for advisers and their clients to tap into the advantages of collared investing either by building their own collars on stocks or through a handful of mutual funds that offer various forms of collared investing.

The momentum behind the strategy is perhaps stronger than it has been in years, which means that we might start seeing more registered products hit the market for individual investors.

With certificates of deposit and money market yields near historic lows, the case for equities is difficult to ignore. Nevertheless, the recent 60%-plus nine-month rally in the S&P 500 hasn't fully made up for the trauma of the preceding crash; all too many investors are still frozen in place.

“The [covered-call technique] has always been seen as a conservative strategy, and the impetus now is that this is seen as a way to hedge risk,” said Nadia Papagiannis, an analyst with Morningstar Inc.

Among the mutual funds using options to manage risk, the 33-year-old, $4.7 billion Gateway Fund (GATEX) is the one most similar to the institutional model.

The Gateway Fund, which is part of Natixis Global Asset Management, buys a group of 300 stocks that represent the S&P 500, then sells index calls and buys index puts to collar the portfolio.

Most of the newer and considerably smaller funds in the category use a more customized approach that involves selling calls and buying puts on the individual securities.

The Lacerte Guardian Fund (LGFIX) moved into the space in October by carving out $20 million from a hedge fund that was employing the same strategy.

Jeffrey Beamer, portfolio manager with Lacerte Capital Advisers LLC, warned that the moving parts of a collar strategy could present major challenges for anyone trying to trade options in their portfolio.

“The investor needs to know that if you sell a call without buying a put, you are synthetically selling a naked put, and the downside is unlimited,” he said.

Another variation of the strategy is employed by Ron Altman, manager of the Aston/MD Sass En-hanced Equity Fund (AMBEX) at M.D. Sass Investors Services Inc., who sells call options on each stock he owns but buys index option puts only as “catastrophic insurance,” and not to offset his calls equally.

The two-year-old fund has seen its assets double to $30 million over the past six months.

“I'm enhancing income and lowering the risk profile,” Mr. Altman said. “In a secular bull market, nobody wants to consider this kind of strategy, but in a cyclical market, this is an interesting way to generate some returns.”

Questions, observations, stock tips? E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.

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