Bill Miller Is Misfiring on Twitter Options After Boon on Amazonby
Derivatives `top detractors' as social media stock plunges
Legg Mason Opportunity beating 98% of peers over three years
Bill Miller turned to an unusual strategy in mounting his comeback as a top stock picker, buying options on hard-hit technology companies to make leveraged bets with a big impact on his returns.
The tactic paid off in 2013 and 2014 as Apple Inc. and Amazon.com Inc. rebounded and helped lift Miller’s $2.3 billion Legg Mason Opportunity Trust to a top ranking. The veteran manager is having less success so far with a similar wager on Twitter Inc. that he escalated last quarter, when he owned options allowing him to buy $350 million of the stock -- equal to 15 percent of the fund’s assets.
The massive wager highlights how some managers are using derivatives to boost profits in mutual funds, tightly regulated investment vehicles that have strict limits on what they can invest in. The technique allows funds to make big wagers with relatively little money up front, though they can lose that money should their bet go wrong. Proponents of the strategy include bond manager Bill Gross, who has said managers need to use leverage to juice up gains in a low-return environment.
“You are going to get a much bigger pop to the upside,” said Abraham Goodfriend, founder of Yedid Capital Management, a Miami Beach, Florida-based firm that employs options. “The downside is, if you are wrong you are going to lose all your money” paid for the contracts.
Miller bought options on 9 million shares of Twitter in the third quarter, filings show. The drop in value of the options may be one reason the fund lost 4.6 percent over the past month and ranked among the bottom 5 percent of peers, according to data compiled by Bloomberg, though it’s still ahead of 95 percent for 2015.
Miller, 65, co-founded Baltimore-based Legg Mason Capital Management and gained fame running its Value Trust, which beat the Standard & Poor’s 500 Index every year from 1991 through 2005. That mark was tarnished in 2008, when the fund got stuck holding too many bank and mortgage stocks amid the credit crunch and lost 55 percent.
He stepped down from Value Trust in April 2012 and now focuses on its smaller counterpart. Opportunity Trust has averaged annual returns exceeding 23 percent since then, and ranks among the top 98 percent of peers over the last three years.
In 2013, Opportunity Trust resumed an approach it last used in 2005: buying call options, in which it pays another investor a premium for the right to purchase a fixed number of a company’s shares in the future at a preset price. The contracts generate a profit if the stock exceeds the exercise price during the term, but expire worthless if it fails to reach the target.
Buying options frees cash to invest elsewhere and allows a fund to bet on a large number of shares with a small down payment, boosting returns if the underlying stock gains. Miller said in an e-mailed response to questions that options occasionally provide more potential reward for the amount of risk being taken than the underlying stocks.
“This almost always happens after the stock has gone down significantly, which was the case with” Amazon, Apple and Twitter, he wrote.
Miller used options amid a bear market for Apple in the first half of 2013, paying a premium of $18.5 million, or $5.29 a share, for the right to buy $250 million of the iPhone maker’s stock.
By December 2014, the Apple calls reached $47.60 a share, or nine times what Miller paid. Opportunity Trust gained $71.5 million from options in 2014, accounting for more than a third of its return. After investments in airline stocks, Apple calls were the fund’s “top contributor” for the year, Miller said in the annual report.
Miller spent a combined $125 million for new calls on $270 million of Apple and $300 million of Amazon shares in 2014’s fourth quarter.
“Technology growth stocks were hit hard in 2014, creating some attractive opportunities,” Miller wrote in the annual report.
In the first half of 2015, as Amazon skyrocketed, the fund gained about $108 million from options, or 60 percent of its return. By Sept. 30, the value of its Amazon calls had almost tripled from the end of 2014 to $194 million, even after the fund had sold 15 percent of the contracts; by Dec. 30, the market value of its remaining contracts totaled $337.5 million, assuming that Miller hasn’t pared the investment since the end of September.
In the first half of 2015, the fund bought 400,000 Twitter shares plus January 2017 calls entitling it to buy 1 million more at $35 each. Opportunity Trust purchased an additional 100,000 shares outright and increased its option exposure to 10 million shares in the third quarter, when warnings of slow user growth by then-interim Chief Executive Officer Jack Dorsey sent the stock sliding.
The fund spent $60 million, or $6.71 a share, on the options acquired in the third quarter. By Sept. 30, the contracts traded at $3.40, and by Dec. 30 they had tumbled to $1.40 as Twitter’s stock closed at $22.23, leaving the calls further out of the money though they have more than a year to recover.
Twitter calls were among Opportunity Trust’s “top detractors” in the third quarter, Miller and co-portfolio manager Samantha McLemore wrote in a shareholder report, when the fund’s 10.5 percent drop exceeded the 6.4 percent decline in the benchmark S&P 500.
Gross, as the manager of the $1.3 billion Janus Global Unconstrained Bond Fund, has been seeking to boost its income by insuring billions of dollars in corporate and sovereign debt through derivative contracts known as credit default swaps. Earlier this month, the SEC issued a rule proposal that would cap the ability of funds to incur leverage through derivatives such as futures and credit default swaps.