Strategies can be implemented
to utilize puts and covered calls.

    In the minds of many advisors, "derivatives" is considered a dirty word. With such debacles as Long Term Capital Management in 1998 and the Enron collapse just four years later, such a connotation may be well deserved. But are there cases where derivatives can earn their keep? And if so, are SMAs cases in point?
    Perhaps such thoughts would be less relevant if the last six years had not included the worst bear market since the 1929 market crash, which ushered in the Great Depression. But strong rebounds tend to make investors complacent, and industry pundits and money managers note the markets now could be a little "long in the tooth" and due for a slight pullback. For SMA portfolios, prudent risk management is part of the ongoing monitoring process. This article will explore the characteristics of SMAs that make them particularly suitable for risk management by using derivatives, and the use of specific strategies being used to implement such management.

SMAs And Derivatives-Ideal Companions?
    Generally, derivatives used alone are considered to be inherently risky instruments. But when coupled with traditional assets in prudent strategies, they can actually mitigate market and other risks. Industry regulatory bodies have recognized this truth over the past dozen years, as is evident in the language of the Uniform Prudent Investor Act (UPIA) of 1994, Section 2.b, which specifically states that for trust portfolios (which are held to fiduciary standards), investment instruments, rather than considered individually, should be considered within "the context of the portfolio as a whole." In light of UPIA guidelines and current market concerns, the prudent use of derivatives to mitigate risk may be in order, depending on a client's investment objectives and other factors.
    Investing in a risk management strategy using derivatives requires knowledge and expertise on the part of the portfolio manager, and a more sophisticated investor as well. Sean Clark, chief investment officer of Clark Capital Management Group in Philadelphia, says, "Typically, the SMA investor is not the investor who is investing in mutual funds. The SMA investor has more experience as well as different needs to accomplish with the portfolio-different constraints. An SMA investor could be someone who has made a lot of money and wants to invest in the market through the use of SMAs so he or she can have more control over the investments in the portfolio."
    Rob Brown, chief investment officer of Encino, Calif.-based GE Private Asset Management, a unit of Genworth Financial that specializes in offering SMAs, says such investors are more thoughtful about the kinds of risk management being used-how robust or solid the strategies are. "If an advisor is trying to address that higher degree of attention, they have to go beyond simply saying, 'Well, don't worry about it-you've got 40% in bonds and everything will be fine,'" Brown says.
    Even so, sophisticated investors need to be educated about options strategies. "Most investors understand the benefits of diversification," says Harry Clark, president and CEO of Clark Capital. For example, he explains "a put is a security that moves in the opposite direction of the market. Covered calls offer the benefit of additional income as well as limited downside protection. There's also a diversification benefit to having put options in their portfolios, and both securities offer tax benefits." He adds, "We assure our clients that we're using options in a very conservative way. We're acting more as the bank and not the speculator."
    Rob Brown's firm created a put option mutual fund to be used along with SMAs in a unified managed account (UMA). "We use put options on popular indices such as the S&P 500, the Russell 2000 and the EAFE index. Put options are a marvelous arms-length risk management technique due to their predictability and the outstanding job they do of defining the worst case," says Brown. The firm offers three levels of exposure-moderate, growth and growth-plus.
    Another benefit, according to both Harry and Sean Clark, is that index options are treated favorably by the IRS. "It doesn't matter if you own it for one day or three years-all gains are treated as 60% long term and 40% short term," says Sean. "So if the market is going down, you're going to have a pretty good gain in your put options, so there's a built-in tax offset there." Covered call writing allows clients to look more objectively at their portfolios at year-end, when they're trying to discern tax consequences.

SMA Strategies Using Derivatives
    The primary reason SMAs are perfect companions for derivatives is because of their highly customizable nature, says Harry Clark. And GE's Brown says derivatives can be used inside UMAs in combination with individual stocks with a very high degree of precision. "We can allocate the exact amount of put option exposure that would seem to be desirable for a given client situation." Brown cites the strategy as a practical alternative to using bonds as risk management vehicles. "In a falling-interest-rate environment, bonds can be a good risk management technique, but in a rising-rate environment owning bonds can be extremely painful." In certain market conditions, bonds also can closely correlate with declining equity markets.
    In Brown's portfolios, the protection is either there or it's not; it's not used to try to time the markets. "You're either going to buy fire insurance for your house or not. So what kind of deductible do you want?" asks Brown.
    Puts can be a low-cost form of portfolio insurance. "Over the last 36 months, put option premiums have been really low because of the positive marketplace and the lack of fear. Brown's group began using the put option strategy in 1998 and believes the strategy is even more timely in today's market. "We believe that interest rates are in for a long climb up," he says, which means greater competition for equities in attracting investment dollars. "We love the put options so much because they're predictable. You know down to the penny and under what circumstances they'll pay off and how much. One can never make such a statement about bonds. From a severity standpoint, if the market falls, 5%, 10%, 20% or even 30%, one knows with a remarkably high degree of precision how much of the loss will be offset by the put options."
    The Clarks use options in four different types of portfolios. They write covered calls in the large-cap GARP portfolio to provide extra income and a bit of downside protection, and in managing concentrated stock positions to provide diversification and also to structure a systemized liquidation schedule. Index put options are used as a hedge for SMA and ETF portfolios.
    "We have clients with large concentrated positions with a low cost basis. They don't want to sell everything at once and be hit with a large tax bill. Through covered call writing, we can set target prices through the options and custom-tailor a diversification and sale program that fits the client's needs," explains Harry Clark. Both Clarks also actively manage the put options so clients can capture profits in the premiums and enhance their returns. Since they only trade index options in popular indexes, the puts are closely correlated to client portfolios. "That gives us excess alpha over the put costs," says Harry Clark.
    Ben Bresnahan, head of investment operations for Drake Management LLC in New York, uses derivatives to manage SMA fixed-income portfolios for ultrahigh-net-worth investors of $25 million or more. "We use indices such as the Lehman US Aggregate because they create a historic return profile, which can be easily understood regardless of an investor's level of sophistication." Bresnahan uses options and swaps to replicate the index to the client's desired level of exposure with only a portion of the client's investable assets. "We essentially can sell a fixed rate through a swap to hedge out the type of pricing activity we can expect when the Fed is raising interest rates."

Eliminate The Obstacles And Add Value
    Along with the natural reaction to the term derivatives, the additional paperwork required for options accounts and margin requirements could be deterrents to employing derivatives in risk management. The mutual fund created at Brown's firm, as the result of 1998 legislation allowing mutual funds to hold options, gets around those hurdles. Concern regarding investors' ability to understand the strategies may also hinder such offerings. "We believe in keeping it simple," says Harry Clark. "We just hedge the structural risks of markets going up and down."
    Although it's impossible to hedge all portfolio risk, the Clarks say such strategies have made wealthy investors much more comfortable about going back into the market after experiencing the 2000-2003 decline. For investors close to retirement, with unprotected portfolios, Harry adds, "If they take another hit of 20%, which we know we're due for, they're just going to be out of luck."
    It bears repeating: Prudent risk management is part of the ongoing monitoring process. Advisors searching for unique and suitable strategies for SMA clients may find that using derivatives to implement risk management in their portfolios is another way of adding real value as well as portfolio protection in uncertain market environments.