In my last post I discussed how ETF’s that hold VIX futures can act as a hedge for your equity portfolio in difficult times. This strategy requires diligent market watching though and a judgement call on general volatility. But some investors (like me) are even more lazy, rather than watch the markets every day, they would rather set it and forget it. Is there a product for them which can hedge or at least offset large drops in the market besides bonds or VIX futures?
There are a few strategies that are within the investing realm of just about everyone which seem to also take advantage of the volatility that big drops can cause. These include a covered call strategy as well as a treasuries and long dated options strategies which can be purchased through various ETF’s.
Call Writing
When you own an underlying stock and write a call option above the current price, you receive a premium from the buyer and would have to deliver the underlying stock for the strike price if the price rises above the strike price of the option. This is called a covered call strategy.
On the surface, it would seem that this strategy limits your upside and would not ever be competitive with going fully long equity. That is because writing a call is a bet that the stock will not rise significantly and the writer of the call can simply collect the premium as the buyer doesn’t exercise the option and it expires worthless.
Yet there has been some evidence that a covered call strategy can actually generate returns that come close to that of the S&P 500 but also offer less volatility. It would seem this is too good to be true but the key is in the way options are priced.
Options tend to increase in value as volatility increases. For this reason, even when the market is undergoing a huge correction, the value of calls tends to increase. If you are holding the underlying stock when this happens, you still get the volatility of the drop in the stock but the option premium rises at that same time, partially offsetting the drop.
In 2015, a study conducted by the Institute for Global Asset and Risk Management, INGRAM, looked at these so called buy write strategies over long periods of time, specifically through the period in the year 2000 to 2014. This is an important and interesting period to look at because it included 2 large drawdowns: the bursting of the dot com bubble as well as the financial crisis of 2008-2009. The authors were able to look at a few different strategies which they summarized below.
The cumulative results of these strategies over the period they examined are shown here:
As you can see through the dark and light green lines that the S&P 500 2% OTM BuyWrite Index as well at the PutWrite index both offered returns in excess of the S&P 500. This in of itself doesn’t have a big wow factor since the returns averaged only about a half a percent annually in higher return. The real difference that makes the strategy become more attractive is that the volatility of prices is lower than that of holding the index. The BXY index ended up being 17.3% less volatile than the index yet produced a return which was 0.5% higher.
There are a few ETF’s which follow the “at the money” strategy for different indexes. They track the S&P 500, Nasdaq 100 and the Russell 2000 and have symbols XYLD, QYLD and RYLD respectively.
I was also able to track down an ETF that tracked the OTM 2% index (BXY above) which is produced by Global X funds and has symbol HSPX. These funds tend to have very high payouts, especially during times of volatility, which the INGRAM study captured.
The key point worth noting is that most of this distribution is considered taxable income, this severely restricts the after tax returns you could see in a brokerage account from these funds as you would have to pay taxes on these distributions annually. An investment in the underlying index will only have the dividends taxed and even those will be at the lower qualified dividend rate. This would mean that the ideal place for this type of strategy would be in a tax advantages account like an IRA.
Other Option Strategies
Most options tend to be short dated, a month or a few months ahead. There is another product which carries more risk and more upside though which are called long-term equity anticipation securities (LEAPS). These options are based on the value of the index over a year out. They be volatile in price because the time to maturity represents more risk. As the expiration date approaches, the value of the index tends to become more certain so the potential volatility of the options decreases.
As we know from the above, volatility increases the value of options so this “time decay” or “theta decay” as Wall St. calls it, can potentially erode the value of the options. Yet if we are in a generally up trending market, LEAP options can allow you to take advantage of the upside of the equity rally with much less downside.
One ETF SWAN, created by Amplify ETF’s, tries to capture this strategy and limit the potential downside. The term Black Swan was popularized by Nassim Nicholas Taleb, a finance professor, writer, and former Wall Street trader. Taleb wrote about the idea of a black swan event in a 2007 book prior to the events of the 2008 financial crisis. Taleb argued that because black swan events are impossible to predict due to their extreme rarity, yet have catastrophic consequences, it is important for people to always assume a black swan event is a possibility, whatever it may be, and to try to plan accordingly.
The way that this ETF tries to plan for such an event is to hold 90% of the assets in 10 year treasuries, and to hold 10% in LEAP options to capture the upside of an equity market. In theory, this security should lose much of the value of the LEAPS when the market falls but the see a big increase in the value of its treasury holdings when there is a drawdown. Luckily, 2020 provided the perfect test for this ETF, which had been in existence since 2018 and it didn’t seem to perform to poorly at all.
SWAN fell 8.9% during the pandemic drawdown in March of 2020 while the S&P 500 fell 31.9% from peak to trough. The flip side of this is that the S&P has rallied about 50% since late 2018 while SWAN has managed only a 32% return. Still though, that’s about 2/3’s of the upside in equities with only a bit more than a quarter of the downside. This is yet another strategy which can help investors grow their savings with less volatility.
Theory Catching Up With Results
The traditional theories which have been pumped to financial advisors and robo advisors are that everyday investors should buy index funds to track a large index like the S&P 500 and add in a portion of bonds with this investment to offset the volatility of the index. Yet persistent low and even negative interest rates in some countries have made this logic weaker. Bonds still rise in value when markets drop but their income potential is severely limited.
This presents problems for those looking for income and forces them to either accept more volatility and more risk, or look for alternative methods to generate income.
It is becoming increasingly clear that new tools available to investors through ETF’s can help them do more than just diversify through indexes, stocks and bonds. They need to diversify their strategies as well. The first step is to diversify from large cap stocks into mid cap and small cap which has been shown to increase long term returns even if only 10% of a portfolio is holding smaller caps. Then, diversifying internationally, for at least a portion of your portfolio, can offer a long term hedge that your home country will underperform for an extended period of time.
I believe the next phase should incorporate strategies that capture volatility and limit the impact of drawdowns (large drops) in the indexes. This can be done with VIX futures, buy write options strategies and combination strategies like SWAN that utilize bonds and long dated options. These strategies do a few things, they either increase in value during volatile times (VIXY and VXX), lose less during a drawdown (XYLD, RYLD, QYLD) or participate in a portion of the upside while limiting the downside (SWAN).
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