A recent investment conference in the Netherlands included the details of a strategy for Dutch pension funds to protect 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.
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 on how pension funds can hedge their equity holdings against a stock market crash.
The main risk: equity portfolio losses
Perhaps 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, 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.
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
It may be prudent to put in place a temporary protection strategy with options. This can be 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.
