Options can limit portfolio volatility

Last week an article on Advisor.ca addressed the use of covered call options to get clients back into equities. Options are not limited to equity investing, they can also be used to limit your client’s portfolio volatility, which makes them an attractive strategy for a wide range of investors.

Using options is a go-to strategy for personal finance commentator Preet Banerjee, senior vice-president at Pro-Financial Asset Management, to protect the downside risk of client portfolios, either through the use of covered call writing or using put options to buy the right to sell a security at a certain price.

When selling covered call options, the client makes a premium on the selling of the obligation to buy a security at a certain strike price. With put options, their downside risk is protected to a certain degree if the stock price falls, because investors can exercise the option and sell the stock at a certain price.

Banerjee says many advisors tend to shy away from using options because they don’t understand them. Purchasing put options carries additional costs for the portfolio and selling calls, reduces the upside potential of security price. Banerjee says an extra 3% to 4% spent to insure a portfolio can be well worth it.

“The best analogy I use is to say buying options is similar to buying automobile insurance. Generally, people understand how automobile insurance works. The bigger your deductible the less your premium. For example, if you’re willing to be on the hook for the first 10% (of downside risk) it’s going to cost x-amount of dollars. It will cost you less if you’re willing to be on the hook for 15% of the losses on portfolio,” Banerjee explains.

“If you engaged in that strategy, and say we’re going to spend probably between 2% and 4% [of the portfolio’s value] per year purchasing puts for portfolio insurance, when the markets lost 30 or 40%, you might have only lost 10% or 15%. The trade-off is you limit the profit. There is always going to be a tradeoff to be made. Most people, in retrospect, would have said it was a fantastic strategy to have employed before the downturn.”

Banerjee also points out that equity collars — a strategy taught in the financial management advisor designation — is something advisors also tend to overlook. In a nutshell, an advisor can sell covered calls and buy put options simultaneously. The investors call option premium income can fund the most, or hopefully all, the cost of applying put options to the portfolio.

Again, as its name suggests, the portfolio has a collar on it so it’s only going to run so far. If equity markets take off in a sustained direction the client will have to sell out large portions of the holdings, and still pay the put option premium.

With a run-up in equity markets, clients are likely interested to get back to investing — but they may remain tentative. Using an options strategy could be a way to get them to dip their toes back into the market. However, advisors would need to stress the upside potential could be limited.

Options on ETFs

There is a robust market for options on ETFs. As exchange listed securities, clients can buy puts and write calls on ETFs. It’s a compelling proposition because as passive products, ETFs have one to one downside risk that is the same as the index. Active management proponents often highlight this as an example of how they add value — by protecting the downside.

Option-licensed advisors who want to protect passive holdings can implement options overlays onto their ETF portfolios, or an MFDA advisor can work with an investment counsel to implement this type of strategy.

One such firm is R.N. Croft Financial Group, which offers Portfolio Index Evolution (PIE) Funds that use options to reduce the volatility of the portfolio. These products are a passively managed ETF portfolio with a set asset allocation. The management adds an options overlay that changes to reflect market conditions.

Croft executes a covered call strategy that overlays an underlying ETF, or, over a replication of the index the ETF tracks,” says Mark Taucar, the portfolio manager of the PIE Funds. “In most cases the PIE funds can have anywhere from 10% to 65% using a covered call strategy that overlays the ETF or the index replication.

Investors tend to opt to use ETF strategies as cost-efficient alternatives to active management since numerous studies have shown the cost differential allows ETFs to outperform overtime. However, adding an overlay strategy can bring out a varied cost.

The PIE portfolios costs have an MER of 0.8% and the firm will pay the advisor of a client a 1% annual service fee. Total MER for the PIE fund then is only 1.8% annually.

Taucar says the overlay strategy can mitigate substantial downside risk for the incremental additional cost.

“You can get fantastic benefits from using a covered call strategy. The research group, Ibbotson and Associates, did a study of the Chicago Board Options Exchange (CBOE) buy/write index in the United States and found [you] can produce the same type of return over a very long period while mitigating one-third of the risk to the portfolio,” he says. “Using portfolio parlance, the standard deviation can be reduced by one-third. If you take a look at some of the standard option writing strategies, one-third of the market drop could have been taken off of the table [in the last downturn].”

Taucar says this research suggests volatility should be treated as its own asset class.

Volatility is highly negatively correlated to equity returns. The VIX (Implied Volatility) is a perfect example of this negative correlation,” he says. “If you put assets that are negatively correlated together, the resulting portfolio becomes far more efficient. The way one can access these returns is through the options market and the use of covered calls; if we use the idea that passive management seems to outperform active management and combine covered call writing, we end up making a good concept [passive management] and make it even better”

Read:

Covered calls help get clients back in equities Getting your head around the equity collar

(08/14/09)