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 low-volatility equity strategies that reduce risk
with index options can be an effective solution to the challenges investors
face. Broadly diversified equity portfolios in combination with index options
and their associated volatility premium can reduce downside risk while
simultaneously allowing for equity exposure.
Over-Pricing of Volatility in Option Markets is a Persistent Global Phenomenon1
Our strategic use of index options can convert 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.
1Based on quarterly averages of expiration to expiration numbers. Cboe®
Volatility Index (VIX®) data available beginning January 1, 1990.
2There are no guarantees Gateway’s strategies will perform as seen in
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
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.