Equity Options and Mutual Funds: Challenges and Opportunities for Future Growth

Mutual funds represent a substantial source of future demand for listed options. Although mutual funds account for an estimated 11% of total activity, TABB Group expects their participation to see sharp growth as they increasingly use options to manage risk and exposure. Their concentrated holdings of equities, need to improve returns and growing demand for risk management tools are all pointing towards future increases in adoption.

Mutual funds have traditionally shied away from using options in their trading activities, as restrictive covenants, the lack of experience, and a general lack of resources to manage the complexity of options trading have presented formidable challenges to greater adoption. However, mutual funds are quickly embracing the potentiality of options, moving beyond basic premium strategies into activities designed to better manage risk and exposure.

The regulatory environment is also fostering demand. Regulators continue to push the industry away from bilateral, OTC instruments to centrally cleared, exchange traded markets. Mutual funds are active users of OTC options, as the structural flexibility and anonymity associated with the products provided an easy-to-use instrument to manage risk and exposures. But as regulatory pressures build, mutual funds will increasingly turn to listed options, especially as the sell side manages their balance sheet to adhere to mandates under Basel III and eventually, Basel IV.

TABB Group believes the mutual fund industry has only scratched the surface with respect to the adoption of options strategies. Mutual funds currently account for an estimated 11% of total US listed options trading but given the magnitude of equity assets under management at mutual funds, they represent an attractive growth area for the industry. Increased industry education efforts, a greater focus on risk management, and increased sophistication of strategies will contribute to future adoption.