Index Option Writing

Pressured by historically low interest rates, many institutional investors have spent the past few years edging into higher-risk assets in search of yield. Now, with short-term rates moving up, equity valuations high and the global political climate marked by uncertainty, a time-tested investment and risk-management tool—index option writing—is looking increasingly attractive. Chief Investment Officer spoke recently with Derek Devens, Managing Director at investment management firm Neuberger Berman Investment Advisers LLC, about how asset owners are using option strategies not just to manage risk but also as a pure source of return.

Q: Asset owners are always looking for new investment ideas and new ways to be more risk efficient, but options aren’t new. Why are people turning to them now?

Derek Devens: Like any industry, investment management has an innovation curve, and in some cases it can take a long time to move from specialized implementations of an idea to broader application. Sophisticated investors have long utilized the optionality that’s embedded in many types of securities: convertible bonds, asset-backed securities, stock warrants, and, of course, swaps. Given the lower return, risk-aware environment we’ve witnessed over the past several years, more conservative option-writing strategies—put-writing, buy-writing and over-writing—are finally moving along that innovation curve.

Q: How exactly does this work? What strategies are you employing?

Devens: One of the most common strategies we use is collateralized put-writing, where, on our client’s behalf, we sell put options on an equity index and invest their collateral in short-duration U.S. Treasury bonds. This allows our client to collect two different return sources—the premium they collect for selling the options, and the bond income. If the index stays above the option’s strike price, the client earns the full amount of those two sources of return. If the index falls to the strike price or below it, the client loses money because they have to pay the put holder the difference between strike price and the index price.  So you do have the full downside exposure of the index, but the downside risk is mitigated by the premiums they received for selling the put, plus any interest earned on their collateral. It’s important to note that the premiums can increase significantly during periods of market uncertainty.

Our second strategy builds on the first. It’s an index strangle where, in addition to implementing the collateralized put-writing, we sell, or write, call options on the same index. This strategy is much less dependent on the direction of the market than collateralized put-writing and at times may even be negatively correlated with the market. Finally, we can implement either of these two strategies as an overlay to increase the capital efficiency of an existing portfolio allocation.

Q: Passive investing is more popular than ever. Options are a type of derivative, and investing in options probably seems to a lot of people like the antithesis of passive investing. How do you square the appetite for these two seemingly contradictory approaches to investing?

Devens: Actually, we suspect they may have something of a symbiotic relationship. As index-based investing has grown, so has the focus on risk control. If no one is actively manning the stock portfolio, then if someone wants to manage the risk of that portfolio further up the chain, at the asset-allocation level, then options can facilitate that.

Q: But to be clear, you’re running actively managed strategies, correct?

Devens: That’s correct. Options are always expiring, so even with a passive strategy the portfolio would be turning over with regular frequency; you’d be rolling your options as they expired or approached expiration. We run a systematic, rules-based strategy. It’s not a tactical or an opportunistic approach, but neither is it a passive strategy where we’re just naïvely rolling options. At a practical level, we can’t advocate a traditional passive approach to options. Exchange traded option markets are transparent. If everybody knew what options we would be selling in a short window every third Friday, other traders would take advantage of it and returns would inevitably suffer. The rules of equity investing don’t apply.

Q: What percentage of their portfolios are your clients allocating to these strategies, where are they taking the money from, and how are they classifying their positions?

Devens: It varies, but we are seeing many allocate something like 5% to 10% of their equity portfolios to these strategies. The money is coming from a variety of other asset classes—hedge funds are one source—but regardless of where it comes from the rationale is often the same. Investors see that these strategies can be an attractive return source that’s index-based, liquid, transparent and cost-effective. Many investors consider it part of their equity allocation, but that’s a little fluid right now. Most of our conversations are around what it is and how it works, and then clients are determining for themselves, often working with their boards or their consultants, how to classify and where this strategy most appropriately fits within their asset allocation mix.

Q: How fast are these strategies growing, and what kinds of asset owners are showing the most interest?

Devens: I’ve been doing this over six years now, and over the last 12 to 18 months we’ve really started to see these strategies gain traction across the board, from health care foundations to big public retirement systems, to smaller municipal retirement plans and even high-net-worth individuals. We’ve raised over $1 billion in the last 12 months.

Q: Options are a form of derivatives, and in the eyes of some asset managers, derivatives still denote risk, not risk mitigation. What would you want someone concerned about risk to know about these strategies?

Devens: First, our strategy really isn’t any riskier than owning equities outright. In fact, I’d argue it’s less risky, in part because the option position is 100 percent collateralized by short-term U.S. Treasuries which means an investor has enough to cover a maximum loss, the index going to zero. We’re not using any leverage. And while our strategy translates into less up-market participation, it has generally resulted in a lower drawdown when the stock market has fallen. My second point goes to complexity and liquidity. We keep things very simple. We only trade listed or exchange-traded index options, avoiding less liquid over-the-counter structures. Finally, we employ a systematic, not a tactical, approach to trading. Where people inevitably make missteps in the derivatives market is by making tactical decisions that result in illiquid positions, too much leverage, and/or too much complexity. I sometimes refer to illiquidity, leverage and complexity as the Bermuda Triangle of option investing; you really don’t want to fly through all three of those at once. We stay clear of all three all the time.

Q: Which indexes do you use for your options strategies?

Devens: Most investors want to source their options premiums from broad-based indexes that match their current equity exposure. The indexes we run, or manage against, for our clients currently include the S&P 500, the MSCI EAFE, the MSCI Emerging Markets and the Russell 2000 indexes. Put-writing and strangle strategies have enough diversification benefits and tracking error to the index that clients don’t need to add to it by doing off-benchmark option-writing.

Q: You mentioned that you take a rules-based approach to your options strategies. What are some of the rules, or variables, that you use to implement your strategies?

Devens: We diversify across expiration dates and strike prices, and we also methodically rebalance options to promote a better, more stable option portfolio.

Q: You must get this last question a lot. What kind of return profile can investors expect from these strategies?

Devens: Historically, putwrite strategies have generated equity-like returns, but with a different return distribution—less volatility, less drawdown in down markets but also less participation in significantly up markets, than the underlying index. For example, since 2007, the CBOE S&P 500 PutWrite Index (PUT) has typically outperformed the S&P 500 in modest, flat and down markets but lagged in strong up markets, with S&P 500 returning 7.18% and the PUT index returning 6.35% annualized during this period.