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.