In March, I attended the 30th annual CBOE Risk Management Conference in Florida and was joined by John Marshall, head of equity derivatives at Goldman Sachs, on a presentation discussing how mutual funds are using options. He shared the chart below which highlights the effectiveness of options-based strategies in reducing volatility and improving Sharpe ratios. One of the goals of our discussion, and the conference overall, was to educate the investment community on the value of options as essential tools that can be used in the portfolio construction process.
The CBOE has been behind this initiative from the start. They have published three indices (BXM, PUT, CLL) which replicate common strategies used in volatility hedging. Below are the descriptions as well as historical returns and standard deviation data of these indices over the past 25 years.
- BXM – designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index
- PUT – designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates
- CLL - designed to provide 3-month S&P 500 Index put options and short one month S&P 500 Index call options
Investors have been following these and similar hedging strategies for years. With CBOE’s indices, investors can now compare performance versus a set of common benchmarks. No matter the strategy, the ultimate goal in building active or passive strategies using options is to expand the efficient frontier. When considering such an allocation, it makes sense to start with a review of the most common volatility-dampening asset class, fixed income.
With the changing interest rate environment, it seems that investors are looking for alternative methods of diversification. The traditional 60/40 allocation is looking more precarious than ever, as forward looking return expectations for fixed income seem unlikely to replicate the returns of the past 30-plus years. Notably, interest rates and credit spreads are near historic lows.
As the global QE programs pause (or possibly reverse course), these factors create uncertainty around capital allocation. So how does an investor minimize volatility given the potential risks? Here, we think options-based strategies provide a solution.
One purpose for utilizing options in a portfolio is to hedge market or individual security risks. Despite recent equity market performance, options strategies still managed to deliver equity-like returns with lower volatility over the past 23 years. These strategies are tied to the S&P 500 after all, and one year is a blip on the radar compared to the length of time these indices have been in existence. As we look at returns over the past several market cycles, the value of options strategies becomes more apparent – especially from a risk-adjusted return standpoint.
As the table below shows, from 1990 through 2013, the rolling 12 month Sharpe ratio of these indices is very compelling compared to an all equity portfolio, as represented by the S&P 500. Here we show that as the time period expands, the Sharpe ratio of the options strategies – PUT and BXM specifically – increases significantly versus the S&P.
In summary, equity markets rarely appreciate as they did in 2013. An important distinction, often misperceived in the marketplace, is that options-based alpha potential depends on the direction of the market. For an options-based strategy, a market that rises 24%, at roughly 2% a month for a year, is vastly different than a market that ends the year up 24%, but arrives there on a course where quarterly returns are up 5%, down 8%, up 15%, up 12%. This is called path dependency.
In the first example, the path exhibits no volatility. In the second, the path exhibits significant volatility where active trading using options could be advantageous (while passive rules-based strategies are at the whim of this path).
For the strategies highlighted above, equity market volatility provides more opportunities for alpha creation. Further, active management within an options-based mandate allows for flexible positioning around the market path, by staggering maturities (expirations) and controlling market exposure (beta).
Regardless of asset prices going forward, volatility looks poised to rise, and with the evidence of options-based strategies as protectors of capital historically, there may not be a better time to consider capturing the unique return characteristics of these strategies.