Case for Low-Volatility Equity
An Index-Option Based Approach
The challenge of pursuing returns while managing risk is increasingly difficult. In an environment where the equity market is defined by the potential for significant volatility and the fixed income market is defined by low interest rates with the potential to rise, many types of investors – from individuals to large institutions – are seeking new ways to achieve the right balance between return and risk.
Over long time periods, diversified equity portfolios have historically generated attractive returns that outpace inflation. However, when equity prices fluctuate significantly, short-term risks create challenges for long-term investors. Increased volatility tempts individual investors to abandon sound long-term strategies and poses unique challenges for institutional investors with long-term liabilities.
At Gateway, we believe strategies that reduce risk with index options can be an effective solution to the challenges that investors face. Equity market exposure combined with index options, and their associated volatility risk premium, can mitigate equity market losses while simultaneously benefitting from the equity market’s propensity to rise over the long term.
Over-Pricing of Volatility in Option Markets is a Persistent Phenomenon1
The frequent over-pricing of implied volatility relative to realized volatility represents a risk premium that creates the potential for option-writing strategies to enhance risk-adjusted return relative to broad equity market indexes. Our strategic use of index options can convert this implied equity market volatility into cash flow while maintaining equity market correlation. This consistent risk profile has the potential for less downside exposure and smaller short-term fluctuations than the underlying equity index. These characteristics may be useful to investors seeking new solutions to the ever-more challenging investment objective of adding short-term consistency to the pursuit of long-term portfolio returns.
Consistent Low-Volatility Equity Profile2
Option writing strategies similar to the Cboe® S&P 500 BuyWriteSM Index (the BXMSM)3 and Cboe® S&P 500 PutWriteSM Index (the PUTSM)4 exhibit “low-volatility equity” profiles: high equity correlation with lower standard deviation and beta, typically resulting in smaller drawdowns and a tighter distribution of returns than the S&P 500® Index5.
1VIX® data available as of January 1, 1990. Past performance is no guarantee of future results.
2There are no guarantees Gateway’s strategies will perform as seen in these charts.
3The BXMSM is a passive total return index designed to track the performance of a hypothetical buy-write strategy on the S&P 500® Index. The construction methodology of the index includes buying an equity portfolio replicating the holdings of the S&P 500® Index and selling a single one-month S&P 500® Index call option with a strike price approximately at-the-money each month on the Friday of the standard index-option expiration cycle and holding that position until the next expiration.
4The PUTSM is a passive total return index designed to track the performance of a hypothetical portfolio that sells S&P 500® Index put options against collateralized cash reserves held in a money market account. The PUTSM strategy is designed to sell a monthly sequence of S&P 500® Index puts and invest cash at one- and three-month Treasury Bill rates. The monthly sequence entails writing one-month S&P 500® Index put options with a strike price approximately at-the-money each month on the Friday of the standard index option expiration cycle and holding that position until the next expiration. The number of put contracts with identical strike prices and expiration dates sold varies from month to month but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the S&P 500® Index puts.
5Selling index call options can reduce the risk of owning stocks, but it limits the opportunity to profit from an increase in the market value of stocks in exchange for up-front cash at the time of selling the call option.
6Post-Tech Bubble drawdown occurred from September 1, 2000 to October 9, 2002. The Great Financial Crisis drawdown occurred from October 9, 2007 to March 9, 2009. The COVID-19 Pandemic drawdown occurred from February 19, 2020 to March 23, 2020.