Can Options Help Retirees Reach Their Investment Goals? by Michael Edesess

Can options cost-effectively enhance investment returns? The answer depends partly on whether the investment manager takes an active view and partly on whether the options can be used efficiently to address an investor’s risk preferences.

Advisor Perspectives has published three interviews in recent months with executives at investment companies who employ options strategies to control risk, to enhance return or both.[1] These investment managers believe their uses of options are effective and beneficial for investors.

Emergency Funds, Retirement
Photo by stevepb (Pixabay)

Let’s look at the strategies each of these managers advocated, with an eye toward determining the likelihood that they will outperform a naïve, passive strategy and offer retirement-oriented investors the type of risk protection they truly need.

Use of options to leverage an active view

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YCG Investments’ Brian Yacktman, interviewed May 16, says they use options to get a better after-tax return on investing in a company that they want to buy than they would get by purchasing its stock outright — if, that is, their view on the future price of the company’s stock is correct. If instead of buying the stock you write an out-of-the-money put on the stock (the strike price is lower than the current price), it’s similar to placing a limit order to buy the stock – but you get the put premium too. This is fine if the stock doesn’t keep on going down.

Writing an in-the-money put can have a similar limit-order effect if the put premium is taken into account in the purchase price. But you have to place a substantial amount of cash in reserve to back up the put’s promise to purchase the stock; therefore, the put premium plus prospective stock rise after purchase has to be enough to beat purchasing the stock itself. Yacktman says that, in almost every case they analyze, the reward is greater for writing the option.

This may be true, but is this just analogous to a leveraged stock position? If the stock or ETF closes below the strike price, yes, you get it for the price you wanted, but at that time it may be worth a lot less than that. Just as the upside may be better than buying the stock, the downside may be worse. An efficient market theorist would say that you’re unlikely to get a free lunch out of this. However, one aspect of YCG’s strategy might produce good after-tax performance even in a perfectly efficient market, if it is tailored to the investor. Besides writing puts on a security instead of buying it, YCG sells covered calls on a security they own instead of selling it. They do both this and their put-writing, Yacktman says, in such a way as to reduce taxes.

Is it possible that a diligent and skilled analyst could navigate the shoals of the options markets and pull out more upside than down? It is certainly conceivable. There are many options available, and at any time there may be what our efficient market theorist would call a “market inefficiency.” But the options navigator will be competing with numerous other skilled (and unskilled) options traders and bots. And of course there will be a cost to the investor, a cost in investment management. And it will be very difficult – extraordinarily difficult, if not impossible – for the investor to assess whether the benefit, if any, of hiring this investment manager exceeds that cost.

This is the dilemma of the modern investor, and why, until the standard of compensation for active investment managers becomes much, much lower, it is advisable for the investor to opt for the simplest, lowest-cost approach. Nevertheless, this admonishment does not rule out the possibility that in some cases – most likely very rare ones – even with highly compensated managers the benefit may exceed the cost — if, that is, one does not include the cost for the investor to accurately glean the information as to which manager can so perform. This cost may become virtually infinite, because the information content of the data available to evaluate investment management is vanishingly small.

Read the full article here.

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