The managers of the £80m Waverton UK fund have begun using call options after shunning the instruments during the rallying markets of 2009.
Russell Wallis and Simon Wilson say the market was so cheap following the Lehman Brothers collapse in 2008, call options would have capped upside potential on the large-cap fund.
"At the end of 2008, volatility went through the roof in the options market," says Wilson. "We saw implied volatilities go up to 60% in the index options market and in certain sectors, such as banks and financials, it was up to 200%."
During this period, the managers took advantage of the high volatility and wrote some short-dated calls against some of the fund's holdings and these expired in January.
"We looked at the market and felt it was cheap. We felt writing options would have lead to underperformance so we did not write any in 2009," adds Wilson.
The duo use an options overlay strategy on a small proportion of the underlying equities in the portfolio to maximise profits and provide downside protection.
As a result, the fund returned 33.18% for 2009 compared to the FTSE 100's 27.33%, according to Morningstar.
However the managers did use some stock substitution in 2009, buying calls instead of the stocks themselves, "to provide some downside protection", says Wallis.
Wilson explains: "Where we did use options last year was through overweight positions by stock substitution, so if a stock goes through a period of weakness it will give some upside potential."
Positions in mining, general cyclicals and financials were the main contributors to outperformance and are still the main overweight areas in the portfolio as the managers are long-term investors.
Wallis says the fund tends to always have a long-term growth skew and this is what the market rewarded.
"Last year we thought we were due a strong rally as things were not as bad as everyone feared. We are now getting to a phase where numbers need to justify the rally and we are seeing this with companies beating estimates."
They have recently written covered call options on approximately 10% of the fund's overall value, with the options due to expire in September.
Wilson adds: "They were written at reasonably good levels and did their job and worked their magic so we closed some positions. This frees us up should we see another rally."
Top holdings throughout 2009 and 2010 include Rio Tinto, BHP Billiton, Xstrata, WPP, Lloyds Bank and HSBC.
"We bought Lloyds last year when we thought it was not quite as bad as people were making out and it had dramatic recovery potential. The original catalyst to buy, however, was the decision not to participate in the Asset Protection Scheme. This means it would not have to pay exorbitant fees. It also has negligible exposure to the Spanish and Greek problems and remains an excellent recovery story," Wilson adds.
