Rebalancing using options
Today, most institutional investors define a strategic asset allocation (SAA) that governs their investments and exposures across all sorts of asset classes. A typical SAA does not only contain a particular percentage point but also an upper and a lower boundary for each asset class. In case market prices of those asset classes move significantly, the boundaries serve as trigger points to buy or sell assets in order to rebalance the portfolio back to the target SAA. Christoph Gort, partner at SIGLO Capital Advisors, provides highlights from a research paper, in association with the Chicago Board Options Exchange, as to whether investors can rebalance a multi-asset class portfolio with such a SAA more systematically and more efficiently by writing call and put options.
THE ECONOMIC thought behind the thesis is simple and empirically proven; writing options yields a premium that can be captured by option writers. If a rebalancing of exposures back to their pre-defined target allocations in the SAA is supposed to be systematically applied in the portfolio, the outcome at the portfolio allocation level should be nearly identical to the option-writing approach. An investor will buy equities in case the price declined and he will sell equities in case the price increased. But instead of a simple wait and see approach, investors who apply an option-writing strategy can earn the option premium and increase performance over time. Indeed, if no boundary is hit during a particular period, investors collect the option premium while the classic approach lacks this additional return.
The paper’s results indicate that a simple rule-based option-writing strategy to rebalance a portfolio using three months out-of-the-money options with the S&P 500 index as an underlying returned almost 7% a year net from 1997 to the end of 2013. This beats buy-and-hold as well as calendar- and trigger-based benchmarks on both absolute and risk-adjusted levels after taking costs into account.
The case for option writing
The idea of option writing in order to collect a risk premium is hardly new as options have been traded for many centuries—mostly on commodities in the earlier days. Today, option writing is regarded as another source of expected returns under certain assumptions. Antti Ilmanen at AQR Capital Management describes one compelling argument for a positive expected return in option-writing with the observation that the buyer of an option is usually interested in hedging and hence willing to pay a premium to his counterparty who sells the option. This thesis is supported by the empirical observation that the implied volatility of options is, more often than not, higher than the subsequent realised price volatility of the underlying asset price, at least in the recent past.
The case for rebalancing
The idea of rebalancing the asset allocation in a portfolio is as old as investing itself. More than 2,200 years ago the ancient investing prescription in the Talmud advised men to split their wealth in three equal weighted parts; one third each in real estate, business and cash. It implicitly assumes regular rebalancing to keep the exposures more or less constant over time. It was in the 1960’s when Claude Shannon explained at the Massachusetts Institute of Technology that a rebalancing strategy on stock markets can add value, while decades later Paul Bouchey coined the term “volatility harvesting” to describe the idea of exploiting mean reverting price patterns of uncorrelated assets. As investors of decent experience will acknowledge, equity markets have indeed been prone to large price reversals in the last decades. More recently, we count three significantly positive phases including the tech bubble in the late 1990’s, the build-up of the housing bubble between 2003 and 2007 and the ongoing recovery from the 2009 crisis. However, these same equity markets also experienced three material drawdowns: the burst of the Tech Bubble from 2000 to 2002, the global financial crisis in 2008 and the turbulence in the fall of 2011.
SIGLO’s paper is basically an assemblage of those two ideas, applied to the practical use-case experienced by institutional investors and their constant proportion SAAs. Given that option writing strategies can offer an additional source of positive returns, and with rebalancing at the heart of institutional asset allocation, it seems only natural to assemble them into one single effort: rebalancing using options.
To keep things simple SIGLO uses a base case multi-asset class portfolio with a SAA of 30% equities, 50% bonds and 20% direct real estate. The upper and lower boundaries for equities are set at 33% and 27% respectively. Popular market indexes like the S&P 500 TR, the Citigroup WGBI and the WUPIXF (listed Swiss real estate funds) were used as asset class proxies. If, for example, equities decline in value, the lower boundary of 27% might be hit and the investor is supposed to buy equities in order to restore the constant proportion SAA allocation of 30% for equities. If, on the other hand, equities continue to perform well, the upper boundary of 33% of the portfolio might be breached and the investor has to sell equities in order to reduce their exposure and get back in line with the SAA. The base case rebalancing in the paper then is simply defined as writing OTM calls and puts with the strike levels corresponding to the upper and lower boundaries of the equity allocation.
SIGLO uses three different benchmarks to compare the results for rebalancing using options to other more traditional approaches. The first one is a purely trigger-based benchmark that instantly and mechanically rebalances when boundaries are hit. The second one is a mix of calendar and trigger-based techniques that rebalance mechanically at the end of every quarter if needed. The third is a pure buy-and-hold benchmark.
Daily data is used for all asset classes and all options in the calculations. The testing period extends from December 31, 1996, up to December 31, 2013, with all calculations in USD. The paper relied exclusively on data provided by the CBOE and only analysed traditional S&P 500 index options. To check the robustness of the results and to screen for more efficient ways to rebalance using options, SIGLO moreover performed a wide range of sensitivity analyses. However, it was key to remain wary of not over-engineering the research process and never aiming to find optimal strategies that maximise historical returns.
Results and comments
The study finds that rebalancing using options enables investors to systematise their portfolio rebalancing while at the same time enhancing portfolio returns and return-risk-ratios. Based on the sensitivity tests, the most effective and efficient rebalancing strategy writes a set of multiple three months call and put options with different strike levels up to the SAA boundaries. Relative to a buy-and-hold approach, the annual return increased by 50 bps while the annualised volatility decreased, leading to a significantly better return-risk-ratio. Relative to trigger-based and calendar-based benchmarks, the annualised returns could be enhanced by 8 bps and 17 bps, respectively, and the return-risk-ratio increased as well. At the same time this simple set of rules also reduced the maximum drawdown during the entire observation period by 100 bps.
For a pension fund managing $1bn, such a strategy translates into a gain of $5m every year, easily financing the necessary operational infrastructure plus the trader who professionally executes the rebalancing using options. Sounds like a pretty good deal, right? Now think of a pension fund with $10bn assets....
Apart from higher net returns and better risk-return-ratios, there is also a psychological argument for rebalancing using options. During the financial crisis of 2008, one observed several cases where the execution of the planned rebalancing approach as defined in the SAA was questioned by decision-takers. Their main argument was based on the fact that financial markets faced exceptional times where traditional strategies were not applicable anymore. With the benefit of hindsight, one now knows that a mechanical rebalancing approach would have significantly outperformed the majority of the observed discretionary decision-takings in the longer run. The observations during a crisis do not surprise people who are familiar with behavioral finance concepts and theories as they know that many investors tend to be driven by psychological patterns like fear, greed or overconfidence. Therefore, the paper argues that rebalancing using options helps systematise the rebalancing processes. This can be beneficial to investors, in particular during periods of significant equity market reversals, because it enforces the required discipline and hopefully avoids panic to take over.
In today’s global market environment with low interest rates and increased challenges to build well diversified portfolios, new sources of returns are scarce but highly rewarding. Adding double digit basis points of extra return per annum while lowering the portfolio volatility and at the same time systematising the rebalancing should therefore quickly find its way into most institutional investors’ toolbox.