If you are like many investors, you will have your beneficiaries’ assets in a diversified portfolio of equities and bonds, alongside a marginal allocation to some alternative assets. In the past, if you thought the business cycle was mature and that equities looked expensive relative to the generous yields you could get from bonds, you would adjust your portfolio from stocks to fixed income. If you thought that a recession had bottomed-out and that equities looked cheap relative to safe-haven bonds, you would adjust your portfolio to position for a recovery in stock markets.
Today, we appear to be nearer the end of a business cycle than its beginning. Equities, as one might expect, look fully-valued, with the U.S. large-cap price-to-earnings multiple rising above 25-times as of the beginning of October 2018, delivering an earnings yield of barely 4%. But after the financial crisis of 2008 – 09 and a decade of below-trend growth and central bank quantitative easing, bond yields are not just unusually low but historically low, and not falling but rising.
In short, neither of the two major asset classes seem particularly good value relative to one another or to their own histories.
Some investors respond to this by increasing their allocations to alternative investments such as equity long/short hedge funds that seek to avoid exposure to the day-to-day volatility of the public equity and bond markets. Others look to pay explicitly for portfolio insurance in anticipation of declines in equity markets—an approach that we regard as ineffective and expensive.1
Others try to reduce portfolio volatility levels by making their equity allocations more “defensive”—by selecting larger companies in sectors that tend to have steadier earnings streams, pay higher dividends and hold less debt—or by selecting stocks that have exhibited lower historical volatility. It is this last approach we find most likely to be challenged at this stage of the business cycle. There is a limit on what can be gained by rearranging the chairs on the deck of the S&P 500.
With the unique challenges facing investors, we believe there is a relatively more attractive option to express defensive equity views that can complement or supplement alternative equity and existing lower volatility equity allocations: writing collateralized index put options.
An Equity-Index Put-Writing Strategy has outperformed when interest rates have risen or declined
| Cumulative Change 3-mo U.S. T-Bill Rate (bps) | S&P 500 Index Total Return | CBOE S&P 500 PutWrite Index Total Return | PutWrite Excess Return over S&P 500 Index | S&P 500 Low Volatility Index | S&P 500 Low Vol Excess Return over S&P 500 Index | MSCI USA Minimum Volatility Index | MSCI USA Min Vol Excess Return over S&P 500 Index | |
|---|---|---|---|---|---|---|---|---|
| Increasing Rates | ||||||||
| Oct 2015 to Aug 2018 | 202 | 14.81% | 8.66% | -6.15% | 12.28% | -2.53% | 13.54% | -1.27% |
| Jan 1994 to Jan 1995 | 297 | 0.51% | 7.32% | 6.81% | -1.26% | -1.77% | -0.09% | -0.61% |
| Sep 1998 to Oct 2000 | 203 | 19.15% | 21.94% | 2.79% | 7.15% | -12.00% | 12.67% | -6.48% |
| Apr 2004 to Jul 2006 | 411 | 8.47% | 9.67% | 1.21% | 10.54% | 2.07% | 10.78% | 2.31% |
| Average | 1.16% | -3.56% | -1.51% | |||||
| Decreasing Rates | ||||||||
| Jan 1991 to Sep 1992 | -364 | 16.00% | 16.15% | 0.15% | 14.64% | -1.36% | 16.28% | 0.28% |
| Oct 2000 to May 2003 | -511 | -12.98% | -5.02% | 7.96% | 6.66% | 19.64% | -6.47% | 6.52% |
| Jan 2007 to Dec 2008 | -503 | -19.79% | -11.77% | 8.01% | -12.01% | 7.78% | -13.20% | 6.58% |
| Average | 5.38% | 8.69% | 4.46% | |||||
| Flat Rates | ||||||||
| Sep 1992 to Jan 1994 | 29 | 14.28% | 14.28% | 0.00% | 12.39% | -1.89% | 15.15% | 0.87% |
| Jan 1996 to Aug 1998 | -22 | 19.33% | 15.54% | -3.78% | 13.55% | -5.77% | 15.64% | -3.69% |
| Dec 2008 to Oct 2015 | 2 | 15.41% | 11.37% | -4.03% | 14.79% | -0.62% | 15.14% | -0.27% |
| Average | -2.60% | -2.76% | -1.03% | |||||
Source: Bloomberg. The CBOE S&P 500 PutWrite Index (PUT) launched in June 2007 with historical backtested data available since 30 June 1986.
