By Michael J. Oyster, Chief Investment Officer, CFA, CAIA
Although frequently attributed to legendary Green Bay Packers coach Vince Lombardi, the quote “winning isn’t everything; it’s the only thing” was first uttered by UCLA Bruins football coach Henry Russell (“Red”) Sanders in the early 1950s. It’s a powerful statement that evokes a level of importance to winning that is all but impossible to understate.
Of all the decisions that investors make, one could argue that only one rises to that level of importance: asset allocation – the process of deciding which broad categories of investments to include in a portfolio and the individual allocation to each.
In our view, some of the most important early work on asset allocation was done in 1952 by a young graduate student named Harry Markowitz*. He deservedly shared in the Nobel Prize for Economics in 1990 for his groundbreaking research on the subject.
Later studies, including several by Roger Ibbotson**, showed that about 100% of the return amount, overall, can be explained by asset allocation policy. Asset allocation typically serves as the primary driver of an investment portfolio’s return. In other words, it’s potentially the “only thing.”
With that in mind, and rightfully so, investors take great care in deciding how to allocate assets.
Portfolios have evolved through time – years ago, many investors who once held only bonds began sprinkling in equities. In some investment portfolios, equities grew to nearly 60% allocations as part of the traditional “60/40” mix between stock and bonds, but it is common to see equity allocations well in excess of that today.
However, with interest rates low and equity valuations high, the expected future return of 60/40 is nearly as pessimistic as it has ever been. We would be foolish to expect investment returns of the future to match those of the recent past. Investors of the future will need to allocate differently to achieve their goals. Drawing upon the power of options-based strategies may provide the solution. But where do they fit within the traditional precepts of investment portfolio asset allocation?
It is often convenient to think of the building blocks of asset allocation in terms of asset categories – stocks, bonds, real assets, and some “catch-all” for strategies that exhibit a low correlation to others is a common starting point.
Where do options fit? Given that options strategies can be constructed to provide a wide range of risk/return profiles, no single category exists in which options will always neatly fit. It can be likened to attempting to categorize mutual funds, with their vastly varied profiles, into a single category. In our view, allocating to an asset should be based upon the asset’s individual risk/return profile and should only be considered if it is expected to improve the portfolio as a result of its inclusion.
Let’s look at one of the most common options strategies: covered call writing (also known as “buy-write”). Covered call writing, in most of its forms, should be classified as equity – more specifically, a better form of equity.
The Chicago Board Options Exchange developed the Cboe S&P 500 BuyWrite Index (BXM), which is a benchmark index designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index. As shown in the graph below, in years when the S&P 500 returns less than 10% (or declines), the BXM has outperformed the S&P 500 nearly every time.
If, as expected, broad equity indexes fail to achieve the stratospheric returns they have almost without interruption over the past 13 years, covered call writing could help make up the shortfall.
Fixed income can also serve two important roles in portfolio construction: 1) Income and 2) protection against equity risk. Options strategies can be constructed to exhibit one or both of these characteristics. Selling calls and puts can generate income. If, by contrast, the concern is equity risk, an options-based hedge can be enacted that very closely matches a specific equity protection goal. In some cases, investors can construct such a hedge while requiring zero out-of-pocket cost.
To us, the key when placing options in a diversified portfolio is recognizing that not all options strategies are created equal. Some strategies can increase expected returns, many others can help reduce risk. Option selling strategies can also generate an additional stream of income. Investors who understand these strategies can deploy them in ways to add value beyond what can be expected from traditional asset allocation – an especially important goal if traditional allocations fail to achieve comparable returns in the future as they have in the past.
[*] “Portfolio Selection”, Harry Markowitz, The Journal of Finance, Vol. 7, No. 1. (Mar. 1952), pp. 77-91.
[**] “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?” by Roger G. Ibbotson and Paul D. Kaplan, printed in the Financial Analysts Journal, January/February 2000.