CFR Working Paper, Provided in Cooperation with: Centre for Financial Research (CFR), University of Cologne Suggested Citation: Cici, Gjergji; Palacios, Luis-Felipe (2013) : On the use of options by mutual funds: Do they know what they are doing?, CFR Working Paper, This Version is available at: http://hdl.handle.net/10419/70483 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen

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... ie Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Using detailed options holdings, we examine how mutual funds' use of options affects performance and risk. Using options generates, on average, no performance advantages. In fact, funds that follow certain distinct strategies underperformed. The only salutary impact is lower portfolio risk for a subset of funds that buy puts for insurance. Perhaps wanting to limit additional losses, these funds also respond to poor performance in the first part of the year by reducing portfolio risk. Our findings suggest no permanent or temporary aggressive risk taking by options users, suggesting instead that some funds use options primarily for risk management. Abstract Using detailed options holdings, we examine how mutual funds' use of options affects performance and risk. Using options generates, on average, no performance advantages. In fact, funds that follow certain distinct strategies underperformed. The only salutary impact is lower portfolio risk for a subset of funds that buy puts for insurance. Perhaps wanting to limit additional losses, these funds also respond to poor performance in the first part of the year by reducing portfolio risk. Our findings suggest no permanent or temporary aggressive risk taking by options users, suggesting instead that some funds use options primarily for risk management. 3 Given these opposing views we investigate two basic questions: (1) what types of mutual funds or portfolio managers are more likely to use options? and (2) how does option usage affect mutual fund performance and risk characteristics? Using detailed holdings of mutual funds at the option position level, we identify 25,789 equity and index option positions held by 250 U.S. equity mutual funds during July 2003-December 2010. Mutual funds use two main strategies, income strategies and directional strategies. Income strategies, intended to generate income, involve covered call or put writing, with covered call writing alone comprising about 60 percent of all option positions. 6 Directional strategies involve purchasing calls or puts to obtain higher positive or negative exposure in a particular stock. Relating the use of options to mutual fund and manager characteristics, we show that certain mutual funds and portfolio managers are more likely to use options than others. The fund characteristics we explore are assets, expense ratios, past returns, and past return volatility, while the portfolio manager characteristics are age, tenure, educational degrees, GMAT scores, and gender. Funds with larger assets under management and higher expense ratios show a stronger propensity to use options. Manager characteristics reflecting different aspects of human capital appear to be related with the likelihood of using options. For example, more experience due to a longer tenure makes portfolio managers less likely to employ options in their portfolios. Among portfolio managers that hold an MBA degree, those with higher GMAT score are less likely to use options, suggesting that a higher level of academic aptitude leads managers to stay away from riskier types of securities. Another interesting finding is that female portfolio managers are 6 The documented prevalence of call writing is consistent with the increased popularity of covered call strategies among mutual funds discussed in the business press (see, e.g.