Options offer a hedge against volatility

Mutual Funds

Some employ strategies in turbulent markets

May 09, 1999|By Bill Barnhart | Bill Barnhart,CHICAGO TRIBUNE

Wild rides in computer-technology and Internet stocks can leave growth-stock mutual fund managers with a strange sense of being observers rather than managers of their own portfolios.

Large, sometimes unnerving price swings in stocks such as America Online Inc. cast doubt on the investment process that stock pickers claim as the essence of their work. No one needs a tour guide on a roller coaster.

Of course, when stock prices are climbing it's hard to complain. But sharp rallies often spell volatility rather than sustainable long-term returns.

As a result, many fund managers are reviewing the powers granted to them in their fund prospectuses to use stock options to hedge the volatility of the stocks that, thanks to today's exuberant market momentum, have become the dominant -- and dominating -- holdings in their funds.

"Any time you have market turbulence, you tend to see an increase in hedging strategies," said Kevin Nowlin, manager of derivative sales at Morgan Stanley Dean Witter & Co. in New York.

Last summer's market correction and subsequent rally prompted the demand for hedging strategies by fund managers, demand that persists amid the current market volatility, he said.

Options give the holder the right -- but not the obligation -- to buy or sell a stock or basket of stocks (index options) at a specified price during a specified period. Buying put options -- the right to sell at a specified price -- on a broad index, for example, gives a mutual fund protection against a market slide. Buying a put option on a high-flying stock offers protection against a crash by only that particular issue.

"It is becoming more mainstream," said David Brady, co-manager of the Stein Roe & Farnham growth stock portfolio, which includes the popular Young Investor Fund.

Nowlin said the use of individual stock options, rather than stock index options, as insurance against market swings is particularly appealing to active equity fund managers.

"The growth in the past few years has been very much on the single-stock side," he said. "You find [fund managers] used to thinking in stock-picking terms. They tend not to define themselves as being market-timers."

The availability of options strategies is alluring. The basic hedging mechanism for most mutual funds is diversification -- holding many stocks, the gains and losses of which offset one another to some extent.

But extraordinary swings in a few stocks -- America Online shot up more than 10-fold between Sept. 1 and April 6 -- may overwhelm diversification.

Buying a put option when a stock is soaring is a way of recognizing the risk inherent in the rally, especially when the risk defies conventional stock analysis. On the other hand, buying and selling options imposes added costs on fund shareholders and may change the character of the fund.

Adopting an options strategy would place a particular burden on Brady's Young Investor Fund, which markets itself to young people.

Here's how the fund's quarterly shareholder newsletter, Dollar Digest, tried to address the issue of market volatility in the fall: "Perhaps the most important reason a company's stock rises or falls is how the company itself is doing," the newsletter said. "Simply put, if a company's profits -- or earnings -- fall (or investors believe they are likely to fall in the future), the price of that company's stock probably will fall, too."

But in today's momentum-driven market, many investors know or care little about the earnings prospects of companies they buy and sell. No one believes that the price action in America Online, which is the largest holding in Brady's portfolio, reflects a reasoned analysis of the earnings outlook.

Using options to counter the dark side of momentum investing may make sense, but it is not a casual decision, said Brady, who has yet to make such a move.

"Simply because a lot of our competitors are doing it is not reason enough for us," he said. "As a portfolio manager, I'm paid to invest in equities. Our decision is that technology is going to be a growth area for a long time to come. Clearly, we're going to overweight that sector. This fund is not going to be the least-volatile fund you own."

When computer-technology stocks briefly hit the skids recently, Brady did not buy put options -- he bought computer-technology stocks.

Pub Date: 5/09/99

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