Investment Strategy On-Demand Webinar Series

Transcription

1 Investment Strategy On-Demand Webinar Series

2 Know Your Options Kevin Hrad, CAIA, Hewitt EnnisKnupp

3 The Required Return Dilemma and the Need to Diversify Institutional investors return assumptions have come down over the past decade, but most still fall between 7.0% and 8.5% 1 Our Capital Market Assumptions suggest it will be challenging to achieve these returns going forward even with high equity allocations Public equities constitute approximately 44% of institutional portfolios, and we estimate that another 15% or so have very similar risk factors 2 The current bull market is into its sixth year, on the high end historically Meanwhile, fixed income assets project low returns for years to come As the search for further diversification continues, we believe institutional investors have largely overlooked a compelling investment opportunity: systematic sales of equity options % of Plans Pension Return Assumptions: S&P 500 Companies 40% 35% 30% 25% 20% 15% 10% 5% 0% 1999: Average 9.2% 2013: Average 7.3% 10% 6% 12% 0% 1% 1% 1% <6% 6 to 6.5% 6.5 to 7% 20% 34% 5% 9% 13% 27% 29% 3% 7 to 7.5% 7.5 to 8% 8 to 8.5% 8.5 to 9% Return Assumption S&P 500 Index Drawdowns: Jan-98 to Jun-13 0% -10% -20% -30% -40% -50% -60% 9 to 9.5% 20% 7% 0% 0% 0% 9.5 to 10% >10% 1 Source: J.P. Morgan Asset Management. Guide to the Markets U.S. 1Q Source: Greenwich Associates, LLC United States Institutional Investors. Greenwich Market Trends. December Investment Strategy On-Demand Webinar Series May 13,

4 The Options Marketplace Options markets have evolved dramatically since exchange-listed options began trading at the Chicago Board Options Exchange (CBOE) According to CBOE, during 2013 over one billion options contracts were traded with nearly 300 million outstanding at year-end All options contracts listed on U.S. exchanges are centrally cleared and guaranteed through The Options Clearing Corporation (OCC), which is equally owned by member exchanges CBOE Total Volume (millions) 1,400 1,200 1, CBOE Total Volume This eliminates counterparty risk for both buyers and sellers of equity options The OCC operates under the jurisdiction of the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) Average Daily Volume 900, , , , , , , ,000 S&P 500 (SPX) Options Average Daily Volume 100, Source: Investment Strategy On-Demand Webinar Series May 13,

5 The Equity Insurance Risk Premium: Why Selling Options Wins Over Time Annualized Change in S&P 500 Index 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Bloomberg S&P 500 Implied vs. Realized Volatility 3-Month Moving Avg (Jan-1990 to Dec-2013) Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan Day Realized Volatility VIX - Implied Volatility Average Realized Volatility Average Implied Volatility There is a persistent equity insurance risk premium inherent in the price of equity options Expected volatility as implied by the market price of options is higher than subsequent realized volatility over 80% of the time by our estimate As with other insurance, premiums earned by selling options are offset by loss events (when options expire in-the-money), and the return is the excess premium income after payouts Per the VIX chart above, realized volatility rarely exceeds the implied level of volatility, which allows investors to keep more premium income than is paid out for exercised options Investment Strategy On-Demand Webinar Series May 13,

6 Options Strategies: Payoff Diagrams The proliferation of the options market has allowed investors to create customized payoff profiles The seller of an option earns a premium and must pay the exercise value if the underlying asset price is above the strike price at expiration in the case of the short call, or if the underlying asset price is below the strike price at expiration in the case of the short put As long as the investor is fully collateralized and unlevered, there is less downside potential relative to a long-only investment because of the premium income earned Notes on the payoff diagram scales: The payoff charts describe a return range of - 100% to 100% for illustrative purposes In practice, an index will usually remain relatively close to current level, especially over the near-term Gain / Loss Gain / Loss $50 $- $(50) $50 $- $(50) Short Call Payoff Diagram Stock Return Short Call $- $50 $100 Stock Price Short Put Payoff Diagram Stock Return Short Put $- $50 $100 Stock Price Investment Strategy On-Demand Webinar Series May 13,

7 Options Strategies: Institutional Investor Varieties The applicable strategies for institutional investors those with a repeatable process and positive mean return can be classified as three different types: Covered call, passive, and dynamic In a covered call strategy, a stock is held long while a call option is sold on the same stock This generates income on the option sale in addition to participating in gains of the long position up to a certain price Near term upside is sacrificed in exchange for a greater distribution of smaller, positive return outcomes Gain / Loss $50 $- $(50) $50 Covered Call Payoff Diagram Stock Return Covered Call $- $50 $100 Stock Price Covered Strangle Payoff Diagram Another strategy, a covered strangle, combines the covered call and a short put strategies If the calls and puts expire at the same time, at least one and sometimes both--will expire worthless Gain / Loss $- Stock Return Covered Strangle $(50) $- $50 $100 Stock Price Investment Strategy On-Demand Webinar Series May 13,

8 Performance The CBOE S&P 500 BuyWrite Index (BXM) and PutWrite Index (PUT) proxy the equity insurance risk premium return profile through passive, rules-based options sales In our analysis, we substituted an equalweighted allocation to BXM and PUT for 5% of the global equity policy in a typical mix of broad equity and fixed income markets Risk-adjusted returns were improved with an allocation to the options strategies Return 10.5% 10.0% 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 100% Barclays Universal 60% ACWI / 35% BC Universal / 2.5% BuyWrite / 2.5% PutWrite Risk-Return: 24 Years Since January % PutWrite 50% BuyWrite / 50% PutWrite 100% BuyWrite 90% S&P/5% BuyWrite/5% PutWrite 65% ACWI / 35% BC Universal 100% DJ US Total Stock Market 100% Russell 2000 Index 100% S&P 500 Index 90% ACWI / 5% BuyWrite / 5% PutWrite 100% AC World Index 5.5% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% Risk Expected Return (%) 14% 12% 10% 8% 6% 4% Return and Risk Comparison Rolling 10-Year Periods Ending 12/31/13 Q Years Ending Dec Years Ending Dec-13 2% Q % 8% 9% 10% 11% 12% Annualized Risk (%) 65% ACWI/35% BC Universal 60% ACWI/35% BC Universal/2.5% BuyWrite/2.5% PutWrite Investment Strategy On-Demand Webinar Series May 13, Growth of $ Dec-89 Dec-90 Growth of $1: 24 Years Since January 1990 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec % ACWI / 35% BC Universal 90% ACWI / 5% BuyWrite / 5% PutWrite 100% AC World Index 60% ACWI / 35% BC Universal / 2.5% BuyWrite / 2.5% PutWrite

9 Risks Like all investments, options strategies have risks with some specific to options sellers In isolation, selling calls will lag sharply rising markets and selling puts will underperform in sharply falling markets, and generally there will be short-term periods when options sales are unprofitable Additional risk factors include the following: Unlike equity index investors who can ride out short-term swings, options sellers are obligated to buy or sell at expiration and thereby dependent on a price path over a defined time range Prices can move beyond a strike price prior to expiration and subsequently fall back below This risk can be mitigated by staggering expirations over time to limit the sensitivity to any particular combination of strike price and expiration date The equity insurance risk premium would likely be reduced if more investors begin to notice All else equal, low implied volatility at inception and low cash yields are less desirable Options strategies tend to struggle within highly volatile whipsaw markets Realized volatility may exceed implied volatility greater chance of landing in-the-money However, higher premiums accompany higher volatility and options premiums are repriced in realtime, so subsequent returns would be expected to improve with an accelerated recovery Investment Strategy On-Demand Webinar Series May 13,

10 Product Universe There is a limited number of high quality institutional offerings, and many have very low levels of AUM, however we have identified compelling products that we recommend for client portfolios This may be due to behavioral influences and misperception of options strategies, namely fear of missing out on the upside or having a liability to pay in down markets Managers have gained traction as institutions search for alternative forms of income Investment Vehicles Products are available in mutual fund, commingled fund, and managed account structures Commingled funds are probably the best means of implementation for most investors Reference Indices Liquidity is more important than beta reference, so most use S&P 500 Index (and ETF) options Strategies may be available on a standalone basis or as an overlay (portable alpha) Fees The multiformity of the product universe makes it difficult to generalize fee structures Slightly higher fees relative to long-only equity strategies for covered call (0.6% to 1.0%) Lower fees for passive strategies that deemphasize stock selection (0.35% to 0.90%) A wider range of management fee (0.0% to 2.0%) and performance fee (20% to 30% of positive returns) structures for dynamic strategies that seek absolute returns Investment Strategy On-Demand Webinar Series May 13,

11 Contact List Kevin Hrad, CAIA, Senior Consultant Investment Consulting Investment Strategy On-Demand Webinar Series May 13, 2014

12 Legal Disclaimer Copyright 2014 Hewitt EnnisKnupp, Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Hewitt EnnisKnupp's preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Hewitt EnnisKnupp disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Hewitt reserves all rights to the content of this document. Investment Strategy On-Demand Webinar Series May 13, 2014