PIMCO Advises Investors to Embrace Options Market

The options market allows investors to prosper amid uncertainty, Josh Thimons of Pacific Investment Management Co. (PIMCO) explains in a recent paper.

(March 5, 2012) — Portfolio managers would be better off using options to more effectively anticipate different market environments, according to Josh Thimons, executive vice president and portfolio manager at fund giant Pacific Investment Management Co. (PIMCO).

Options allow portfolio managers to express a specific view conditional on the direction of the market, Thimons concludes in a recent paper.

According to the paper, the performance of most investments over the coming months will likely depend directly on the outcome of the European debt crisis. “Often overlooked as an asset class and traditionally used to hedge other risks, options – puts and calls whose prices depend on the level of implied volatility – exist in virtually all major markets. In the current turbulent market, we see opportunities to construct portfolios using options that can potentially benefit in a myriad of possible outcomes in Europe,” Thimons asserted, noting that most users of options tend to be large market participants hedging business risks. He continues: “Rather than choosing whether Europe will improve or deteriorate, options can be used in such a way that they kick in only if Europe improves or deteriorates.”

He concludes that investors can “potentially prosper even if they admit that the outcome in Europe and the timing of that outcome are anything but certain.” Therefore, according to PIMCO, options are one tool that allows investors to admit a lack of omniscience and prosper amid uncertainty.

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With PIMCO’s overall encouragement about the benefits to investors of using options amid an uncertain market environment, how are institutional investors using them, and more importantly, are they using them effectively?

While there is still a general concern among institutional investors about effectively using options, schemes are increasingly using these investment vehicles to hedge against interest-rate risk, many consultants say. Mercer consultant Gordon Fletcher noted he has witnessed a much greater interest in derivatives among corporate funds as they look into derisking strategies amid an environment of frozen legacy liabilities. “We’ve seen a growing number of especially corporate pensions using derivatives as they pursue liability-driven investment,” Strategic Investment Solutions’ Managing Director John Meier told aiCIO. “If you’re trying to lower pension surplus interest rate risk, using derivatives is definitely effective in order to maintain a reasonable level of return.”

Meanwhile, according to Jeffrey MacLean, the CEO of Seattle-based Wurts & Associates, most large institutional investors at the portfolio level utilize options without relying on the use of investment consultants, due to the deep expertise needed to implement such strategies. “Implementing tail risk hedging strategies requires experience that you do not often find with traditional consulting firms…For Plan Sponsors with internal staffs capable of placing tail risk hedges on the portfolio level, it is important for them to have the right governance structures in place to properly implement them.”

MacLean continued: “If you’re using options to implement tail-risk hedging, for example, you want someone who has done it for lots of years and understands all the complexity — having someone doing it on a part-time or non-discretionary basis does not make sense.”

(March 5, 2012)—Despite housing some of the world’s most sophisticated asset owners in its public pension sphere—the Canadian Pension Plan and Ontario Teachers’ Pension Plan among them—Canadian plan sponsors are concerned about immediate and long-term threats to retirement assets.

According to a study released this month by consulting firm Towers Watson, 65% of Canadian defined benefit (DB) plan sponsors “believe that Canada is experiencing a pension crisis that will be long-lasting and likely to worsen in the next 12 months.” This number is up from 56% in the 2011 iteration of the Pension Risk Survey, which asked 115 plan sponsor executives for their opinions on a variety of subjects.

Furthermore, the study says that 54% of DB sponsors are “currently planning or considering investment strategy changes, typically to de-risk their portfolios,” according to a release from the consulting firm. “In contrast to prior years when plan sponsors were more focused on seeking higher returns, 53% of 2012 respondents (compared to only 36% in last year’s survey) appear willing to accept lower returns in favour of reduced risk,” the release adds.

“Until a few years ago, plan sponsors remained caught in the mindset that de-risking meant giving up more return than they felt was worthwhile,” says David Service, Director of Towers Watson Investment Services, in the release. “Many plan sponsors did not take advantage of the de-risking opportunity that existed in 2006 and 2007 when their DB plans were close to fully funded. After another volatile year of market performance and declining funded status, sponsors now seem more inclined to focus on de-risking their DB plan—even if at the price of lower returns.”

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The release does not make clear whether the DB plan sponsors polled included the mega-plans that many think of when they consider Canadian retirement assets.

Other revelations from the survey include:

· With pending pension legislation, “a majority of respondents cit[ed] permanent extension of amortization periods (59%) and extensions to temporary funding relief (57%) as being within their top three priorities,” according to Towers Watson.

· Only 2% of current private sector DB plan sponsors expect to alter their plan structure towards a defined contribution plan in the next year.