October 27, 2009
The main effect of using QQQQ is that the total volatility and expected return from the call options increases because QQQQ has higher volatility than SPY. QQQQ has a lower correlation to TIPS than SPY does, which confers a little more in the way of diversification benefit — it mitigates very poor outcomes slightly. QQQQ also has a substantially lower dividend yield than SPY, which increases the potential payout from the call options.
Buying calls on a higher beta / lower yield index ETF adds some additional benefits to the 90/10 strategy. There is an additional change in the outcome of a 90/10 type of strategy in buying calls on options with beta greater than 100% relative to the S&P 500: One can further increase the effective leverage with respect to the S&P 500. Higher beta assets tend to further amplify moves in the S&P 500. The beta of QQQQ is 1.09 (see note at the end of this article).
Let’s take this idea a step further with another example. We start with 90% invested in TIPS and 10% invested in one-year at-the-money call options on an emerging market ETF, EEM. EEM has higher Beta than QQQQ, as well as higher volatility (see note at the end of this article). There are, of course, other reasons why one might choose to have equity exposure through emerging markets rather than the S&P 500. EEM’s returns have an 89% correlation to returns on SPY and a Beta of 1.46 with respect to the S&P500. The outcome of the 90/10 is shown below.
90/10 portfolio with call options on EEM
In this portfolio, the worst downside is no worse than that from the original 90/10 portfolio because the maximum downside on the equity call options is the 10% of the portfolio paid in options premium.
Bodie’s 90/10 strategy can be sanity-checked using Monte Carlo simulations and by benchmarking using the current prices of index options vs. the Monte Carlo model. Using this framework, it is straightforward to look at how variations of the strategy impact outcomes.
There has never been any doubt that the basic mechanism that Bodie proposed could work. The question has been whether such a strategy would work in practice, given the prices at which options are trading at any specific time. As the prices of options vary, the effective leverage changes. Given current options prices, the 90/10 strategy makes sense today.
A range of practical variations on the 90/10 type of strategy can make sense for retirement planning. Their main attraction for investors is the absolute floor that they provide on the equity portion of the portfolio.
One of the largest challenges to this type of strategy is its conceptual complexity. On the other hand, as Bodie has noted, equity-linked notes that provide this type of structure to retail investors have been adopted fairly widely in Europe. Advisors who take the time to create their own 90/10 and related strategies can provide a floor on equity market loss potential, while maintaining transparency and keeping costs down.
Notes on the Monte Carlo simulation
The projected returns, volatilities, and correlations for the various asset classes have been generated using Quantext Portfolio Planner (QPP). The only adjustment to baseline settings is that the volatility of the S&P500 has been raised to 24% to be consistent with current implied volatilities of long-dated options. With this single adjustment, the higher volatility on the S&P500 drives changes in the volatilities of the other asset classes. The results are shown below, along with current implied volatilities of long-dated options.
The volatilities projected by QPP are very close to the current market levels, which is reassuring in terms of a consistent spectrum of risk across asset classes.
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