Since Sept. 30, 2012, the S&P 500 is up 16.7%. The Sharpe ratio of the monthly returns over those 12 months was 1.84. This is nearly twice the risk-adjusted return of the average 12-month period for the most common equity market barometer since 1928.
Why are we citing these statistics to kick off this edition of the Volatility Advisor blog series? We’re highlighting this anomaly of short-term performance not simply to demonstrate the impact of QE on the equity markets, but to set the table for an expansion on last’s month’s topic: to make the case for a hedged equity allocation as part of a portfolio.
The S&P’s momentum has created a market of cheap premiums and fewer opportunities to arbitrage implied volatilities. From a fundamental standpoint, one could point to record profit margins, P/E levels or rising interest rates as indicators that the rally is over-extended. But ask traders and allocators whether they think the next move in the market is up 20% or down 20%, and you’re likely to get an equal set of responses.
In a market that many investors believe to be increasingly affected by Fed policy, what’s becoming a concern is portfolio managers’ ability to maintain discipline in the face of rising equity markets and relative underperformance. Whether the market continues to climb from here or not is out of portfolio managers’ hands. What can be anticipated is that, eventually, volatility will return to the markets. When it does, protection via options strategies may smooth the ride.
Since inception of the CBOE BXM Index as a published index in May 2002, index returns have proven the validity of covered call strategies as risk-return enhancing components of a portfolio. These results occurred despite the steady rally of the past year.
Shown a different way, look at the comparison of monthly and daily return distributions of the two indices. By design, the BXM provides a less volatile return stream. For investors focused on long-term performance, the risk-adjusted return impact is likely to be additive to the portfolio.
If we focus our attention inside the tails of these distributions, we see further the value of a covered call writing strategy during normal markets. Since the BXM Index inception, 71% of monthly returns have been between -4% and +4%. During these months, the BXM has captured 119% of the return of the S&P 500.
The BXM’s long-term upside capture of 64% vs. 72% on the downside is not particularly desirable at first glance. But taken in the context of the return capture of the past 12 months that we highlighted at the onset (19% of S&P since 9/30/13), this balance is understandable. Of course, the stated strategy of the BXM is to cut off some of the upside by writing at-the-money calls on the SPY each month.
Another way of demonstrating the value of owning BXM-like volatility is during the most extreme environments in the equity markets. The following chart from the CBOE depicts several of the most volatile periods in the market over the past 20-plus years. Please note this return period extends the BXM Index to years prior to its official published date using the same methodology that currently exists of rolling monthly covered call options.
What stands out is the protection the BXM provides during down markets. Just as appealing however, is that in strong up markets the index generally keeps pace with the S&P 500.
So where does this leave the equity investor that has made roughly 20% thus far in 2013? Again, with the macro headlines today and the lack of compelling alternatives on the traditional side (fixed income, cash), the advantages of an equity substitute with a structural objective to reduce volatility could make sense.
As investors continue to seek daily-liquid assets that are less correlated and/or hedged, the BXM and strategies focused on delivering similar return characteristics may begin to draw investor attention.