Can Mutual Funds Invest in Options?
Several mutual funds implement options strategies. While mutual funds are highly regulated investment products, options are too. Most mutual funds attempt to construct portfolios of securities that deliver meaningful performance as compared to a widely recognized benchmark, such as the S&P 500 Index. If you follow the markets for any time, you will recognize that even popular indexes can lose substantial portions of their value. This is where the use of options can be of benefit.
Other People Are Reading
-
Mutual Fund Portfolio Construction
-
Mutual funds create large portfolios of securities based on any number of selection criteria. Those security positions can be managed in several ways. Most fund managers will try to keep a stock selection in the portfolio until it no longer meets their criteria. In the meantime, the overall market -- and fund -- can experience wildly varying conditions. It may race higher by 40 or 50 percent or it could decline by a similar amount. The period from 2000 to 2009 demonstrated just this: it began with a significant decline, rallied handsomely, and then lost half of its value again. Most mutual funds did not avoid those declines, and many investors were unable to tolerate the volatility.
Option Basics
-
Options are available in two types: calls and puts. Each can be either bought or sold. Calls appreciate in value as the underlying security it represents rises in price while puts increase in value as the security declines in price. They have a predetermined life span. The option's price is made up of both intrinsic value and time value. Intrinsic value is the positive difference between the price at which the security is controlled and the security's current price. Time value is associated with the remaining period to expiration. Options are a "tool" that allows the assumption or transfer of risk.
-
How Mutual Funds Can Use Option Strategies
-
Many mutual funds simply buy stocks and hold them regardless of what the market -- and securities -- do. As a result, they assume the full risk of market swings. On the other hand, some fund managers employ hedging strategies when they have judged the market to be susceptible to a decline. Rather than selling the underlying securities, they can purchase "insurance."
Just as a car or home owner can insure his property, a fund portfolio manager can insure the portfolio. In this case, the manager might buy index put contracts that would expire after her perceived risk has abated. If the market and fund portfolio have declined, the put contracts will have appreciated in value, thereby offsetting the lower value of the portfolio. In the opposite view, the manager may also use call options to gain exposure to a perceived market rally. These are just two strategies that can be used.
Impacts of Option Strategies on Mutual Fund Performance
-
Many people view options skeptically. It's true that most option speculators perform poorly, and many people have traveled the road to ruin by not using options properly. Others see hedging strategies as a form of market timing and that it can not work reliably, therefore it is pointless. However, it should not be confused with risk management. Many portfolio managers have demonstrated that they can reliably identify periods of high market risk.
Owning portfolio insurance in times of market distress can reduce the magnitude of fund portfolio losses. Even in light of the less expensive to operate, non-hedged mutual funds, ending the day with more value -- capital preservation -- sets the portfolio up for improved performance on the next leg up in the market.
-
