Main Play: Selling Options As A Long-Term Strategy With ETFs

When four Montgomery Securities executives decided to break away from the large West Coast investment brokerage in 2002 to start their own asset management shop, they opted to use only exchange-traded funds.

"Even though we all came from a background of managing money using individual stocks, we felt the bear market of 2000-2002 really exposed the advantages of using ETFs," said Kim Arthur, one of the institutional money managers who left to start Main Management LLC.

Since opening its doors in the heart of San Francisco's financial district more than six years ago, the firm's founders say they've focused on asset allocation in portfolios rather than individual security selection.

Arthur is responsible for running Main's investment committee and constructing client portfolios. "We're more reversion-to-the-mean investors than buy-and-hold investors. So when market volatility is higher, we tend to make portfolio changes a little more quickly," said Arthur.

When sectors drop out of favor, Main's analysts and managers like to move into what they see as underappreciated parts of the market.

But Arthur and his staff don't consider themselves deep-value investors. Before initiating positions in an ETF, they demand that at least one catalyst for growth be present with demonstrated abilities to lift a sector's performance.

Typically, Main's team is looking for catalysts that can spur improvements in an industry's bottom line within a quarter or two. "It can take much longer for a new growth cycle to be fully realized," said Arthur. "But if we don't see positive movement of some type within a quarter or two, then we'll typically formulate an exit strategy for funds we're using to capture that segment of the market."

He says another important ingredient in the firm's investment approach is to wade into positions as sectors show greater promise. "It's a process that keeps us out of value traps and can be described as a little on the GARP-ish [growth at a reasonable price] side," said Arthur.

The firm's average client portfolio has an annual turnover ratio of around 25%, according to Main analysts. Among mutual fund managers categorized as focused on growth, industry statistics show those portfolios average more than 100% in turnover a year.

"We make changes on the edges of portfolios," said Arthur. "We're looking to hit singles, not home runs."

Main's managers start with a model allocation, which is reviewed and reallocated yearly. But Arthur and his co-managers monitor portfolios throughout the year and make tactical tweaks as market conditions demand, he says.

One of those came in the fourth quarter of 2008. When the S&P 500 dropped to the 780 level, Main's investment committee decided to reduce cash positions and buy more equities. "We thought from a valuation standpoint, it was a good time to replenish our clients' equity positions, which had fallen quite a bit below their allocation targets," said Arthur.

The firm bought SPDRs (NYSE: SPY), the iShares Russell 1000 Growth Index (NYSEArca: IWF) and the iShares S&P MidCap 400 Growth Index (NYSE: IJK).

"All of these ETFs have Technology and Consumer Discretionary exposure. Those are the sectors that usually move more aggressively in bear market rallies," said Arthur. "We're not trying to market-time. But we continue to rebalance portfolios into growth sectors that tend to outperform in a bear market rally."

Those moves combined to overweight portfolios to larger-cap and growth-oriented stocks represented about a 5% shift of overall client assets, he added.

Heading into the new year, U.S. equities made up about 44% of the firm's all-asset core model portfolio. Another 16% went into international equities. Those included WisdomTree DEFA (NYSE: DWM) and the iShares MSCI EAFE Index (NYSE: EFA) to cover developed foreign markets. For developing countries, Arthur uses iShares MSCI Emerging Markets Index (NYSE: EEM).

Domestically, some 25% of Main's flagship all-asset model portfolio is devoted large-cap core ETFs. Another 5% is invested in the iShares Russell 2000 Index (NYSE: IWM).

"We prefer to use core domestic ETFs with the best liquidity levels," said Arthur. "You can save 35 basis points or so with lower-priced funds from Vanguard and other providers. But an important part of our process is using an options overlay to our standard equities models."

Main prefers to sell options rather than buy them for a select number of core domestic equity ETFs. "Seventy percent of the time, options expire and turn out to be worthless. If you write that option, you get to keep that dollar rather than losing it," Arthur said.

He uses options to dampen volatility. "You get a yield enhancement from the underwriting. So it's like getting another income source to boost your overall portfolio's return," said Arthur.

Such an options strategy has been a big plus during the latest recession, he notes. And it continues to help cushion market bounces, says Arthur, even though market volatility has been cut in half from peak November 2008 levels.

"But on an absolute basis, volatility is still very much present and we expect to continue to see markets trade in very wide ranges," he added.

Main Management normally holds up to 25% of its portfolio in noncorrelated assets. These include everything from Treasury Inflation-Protected Securities to currencies, commodities and real estate.

"But in 2008, those investments have become more correlated with the broader market. So with the exception of TIPS, we have significantly reduced exposure to those alternative asset classes," said Arthur.

While deflation is more of a short-term concern, he adds that in two years, inflation figures to be a bigger problem. As a result, Main is using some iShares Barclays TIPS Bond (NYSE: TIP) in client portfolios. "We're not adding to those positions, but unlike the other noncorrelated ETFs, we're certainly not selling any shares of TIP at this point," said Arthur.

The firm has completely gotten out of currencies. It still holds some exposure to real estate and commodities, however. Those ETFs and exchange-traded notes include the iPath Dow Jones-AIG Commodity Index ETN (NYSE: DJP), the PowerShares DB Commodity Index Tracking Fund (NYSE: DBC) and the Vanguard REIT Index ETF (NYSE: VNQ).

Noncorrelated assets are down to about 15% of total assets. The remaining 25% is currently in cash and fixed income. "We're generally remaining with shorter-duration bond funds and exclusively sticking to Treasuries," said Arthur.

Those include iShares Barclays 1-3 Year Treasury Bond (NYSE: SHY), iShares Barclays 7-10 Year Treasury (NYSE: IEF) and iShares Barclays 3-7 Year Treasury Bond (NYSE: IEI).

"Even though yields on Treasuries are really low right now, we're more concerned about safety. In our all-asset core model portfolio, we're using fixed-income allocations to dampen stock portfolio volatility," said Arthur.