Oahu, Hawaii.
Photograph by Getty Images/RooM RF
By Stephen Gandel
August 22, 2016

Several pension funds are betting that Wall Street’s stock market bull has more years to run.

Pension managers in Hawaii and South Carolina have been putting money into a derivative investment strategy that will pay off if stocks either rise or stay flat. If stocks plunge, however, the pension funds could lose big.

The strategy appears to have been pushed by Pension Consulting Alliance, a firm that advises the giant retirement funds on how they should invest. According to the Wall Street Journal, PCA pitched the strategy to Hawaii’s pension fund last year with a prepared presentation. It’s not clear how many other pension funds got the same pitch. PCA did not return a call for comment.

Institutional investors and some individuals typically protect themselves from losses by purchasing so-called put options against stocks they hold in their portfolio. Put options make money when stocks drop. If the stock rises instead, the investor offsets any losses it has on the put option with gains earned from the stock.

The pension funds in Hawaii and South Carolina are taking the other side of that trade, selling puts to those investors looking for protection. Unlike the other investors, though, it appears the pension funds are writing puts nakedly, meaning the derivates they are selling are not specifically tied to other investments in their portfolio.

That won’t be a problem if the stock market stays where it is or goes up. If that is the case, the pension funds will be able to pocket the fees they are collecting for selling the puts to other investors. But if the stocks connected to the puts were to plunge, it could leave the pension funds will big losses.

Generally, it appears investors believe stocks are headed up. But a number of prominent people have recently warned that they see a potential huge crash coming for the stock market. Back in May, Donald Trump said he thought all the money pilling into tech stocks reflected a bubble that could burst. Trump supporter, Carl Icahn, too, has said that he believes a stock market crash is coming. Trump could be a problem as well. Earlier this month, Shark Tank star and investor Mark Cuban predicted that the stock market would crash if Trump were elected president.

For now, however, the pension funds seem to be doing okay, even if put writing strategies are trailing some broader market indices. The pension funds appear to be only writing the puts against the S&P 500, not individual stocks. Betting against a diversified portfolio makes the strategy less risky. What’s more, pension funds are typically large, and have cash and other liquid assets that could be used to adsorb losses.

And for investors in general the pension funds move is a positive sign. It means that a number of large investors are still betting that the stock market will continue to rise. That’s good news for all of our 401(k)s.

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