Low Volatility vs Option-Based Strategies

Core Equity Alternatives

October 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Option-based strategies have similar characteristics to Low Volatility portfolios
  • Combining these reduces idiosyncratic strategy risks
  • The combinations feature higher risk-adjusted returns and lower drawdowns than the S&P 500

INTRODUCTION

Some investment products and strategies can be considered toxic given their history on Wall Street. Portfolio insurance is rarely used in marketing materials, given its role in the 1987 stock market crash. CDO-Squared instruments and structured investment vehicles (SIVs) are also unlikely to make a major comeback as they were at the epicentre of the global financial crisis.

Less toxic, albeit still frequently viewed critically by mainstream investors are hedge funds, managed futures, structured products, amongst others. Mostly these concerns are justified based on poor performance and are typically related to complexity, which make risk-return decisions challenging (read Hedge Fund ETFs).

However, some of these complex strategies have become available as ETFs, which represents a game changer as they will be traded on a regulated stock exchange and usually offer full transparency by tracking an index with a documented methodology.

For example, option-based strategies like covered call and put writing were launched as ETFs and aim to offer equity-returns with reduced downside, similar to Low Volatility strategies. However, investors have allocated barely above $1 billion of assets to option-based ETFs, compared to more than $80 billion in Low Volatility ETFs, which is challenging to explain.

In this short research note, we will compare option-based and Low Volatility strategies as well as consider these as alternatives for core equity positions.

METHODOLOGY

We utilize the CBOE S&P 500 BuyWrite Index (BXM), which employs a covered call approach that buys the S&P 500 and sells at-the-money calls on the index, and the CBOE S&P 500 PutWrite Index (PUT), which sells at-the-money S&P 500 puts and invests the cash in short-term Treasuries, as option-based strategies.

We construct two Low Volatility port