Performance-Benchmarked Portfolios

Stock options were originally intended to tighten the link between executive pay and performance. In practice, however, they've proven to be a clumsy tool. In the bull market of the 1990s, options enriched many a mediocre CEO, while the economic slump that opened this decade has punished weak and strong performers alike.

Conventional options have that effect because they focus on absolute performance. As a result, they both reward and punish managers for factors, such as market movements, that are beyond their control. In order to filter out these effects, many analysts have suggested that companies scrap their existing programs in favor of indexed options. Under one such proposal, companies would reset the price of their options each year in order to reflect changes in a market benchmark, such as the S&P 500. If the index rose 10%, for example, the exercise price would also increase by 10%, allowing a CEO to cash in only if his share price had grown by even more.

The idea behind indexed options is to reward executives who outperform the market or industry peers. But as Harvard Business School finance professor Lisa K. Meulbroek demonstrates in a December 2001 working paper, they fail to achieve that goal. A simple example makes this clear. Say an executive receives an option with a $10 strike price, and the market price of the stock is initially $12, giving the option an “intrinsic value” of $2. One year later, the company and the market have both gained 10%, making the share price $13.20 and the strike price $11. If indexing worked as intended, the option's intrinsic value would remain the same. In fact, however, at $2.20, it has also risen 10%.

A similar result holds for options granted at-the-money — that is, when the exercise price and the market price are initially the same. In this case, the option's intrinsic value is zero, but it is still worth something — say $1 — because part of an option's total value stems from uncertainty about future price movements. Consequently, if the market and the company both gain 10%, the option's value increases by the same amount. More generally, changes in the option's value do not match the company's performance relative to the market.

In place of indexed options, Meulbroek suggests that companies seeking to reward relative performance adopt an alternative design: options on a “performance-benchmarked portfolio” constructed of a company's stock, hedged against market and industry movements. Under this plan, the portfolio's value changes, while the exercise price of the option remains the same.

In its simplest form, the portfolio consists of one share of the company's stock, a short position in the market (which amounts to betting that the market will fall) and a corresponding amount of a risk-free asset, such as short-term Treasury bills or cash. The proportions of the three assets are given by the stock's beta, which measures its correlation with the market. For a $10 stock with a beta of 1.0, the portfolio would hold one share, a short position in the market worth –$10, and $10 in a risk-free asset, for a total value of $10. If the company and the market both gain 10%, the stock rises to $11, the value of the short position falls to –$11, and the value of the portfolio — and therefore of the option — is unchanged, exactly the result that advocates of indexing seek.

The portfolio can be adapted to benchmark performance against companies in the same sector, rather than simply against the market as a whole, by incorporating a short position in the industry “ex-market” — that is, correcting for the correlation between the industry and the market. While this procedure may sound complex, it need not be implemented literally, Meulbroek points out. “The firm doesn't actually have to go out in the market and buy and sell,” she observes. It can just identify and track the appropriate market and industry indices in order to calculate the portfolio's worth.

The approach aligns shareholders' and executives' interests by exposing managers solely to company-specific risk. But it also has the potential to reduce executive compensation, even when managers outperform the market or their peers. The performance-benchmarked portfolio works by “stripping out as much volatility as possible that doesn't affect the manager's incentives,” Meulbroek explains.

To date, only one major corporation has adopted an option plan that targets relative performance. However, Meulbroek believes that may change as new players, including Wall Street banks, are bringing a fresh perspective and new skills to the business of compensation consulting.

Meulbroek's paper is titled “Designing an Option Plan That Rewards Relative Performance: Indexed Options Revisited.”