Financial markets have been experiencing some of their wildest trading days in history this year. How wild? Starting April 4, the S&P 500 lost 10.5% one day only to gain 9.5% in the next few sessions. For perspective, U.S. stocks to that point had averaged a 10.3% move over the last century. Reportedly, even the most experienced traders wobbled under the ferocity of the moves. As Hetty Green, one of Wall Street’s most esteemed observers once said, days became years.
Less reported, but just as important, while stocks were gyrating, bonds were swinging in a similar manner. An outsized bond selloff actually sent 10-year Treasury yields climbing to levels not seen since 2001. The short-term price action of Treasuries, which historically have been a haven in turbulent markets, seemed nearly impossible. But it was.
TIME FOR A CHANGE?
In extreme markets, it’s only normal for investors to at least contemplate extreme changes in their own portfolios. Fortunately, there are experienced advisors out there to remind them that now is no more the time to ‘buy the dip’ than it is to ‘dump everything.’
But the sight of stock and bond prices moving in unison has to be a bit alarming to investors and their advisors. Is now the time for asset allocators to consider an important strategic reallocation?
We’re not the first to suggest that long-term portfolios might benefit from additional exposure to alternative strategies within their portfolio allocations. Further and with an eye toward managing portfolio risk, reallocation towards smart options-based strategies can be beneficial, especially in a volatile market.
THERE’S A REAL ALTERNATIVE
And just what are these options-based strategies? There are all kinds of option programs, but the ones we’re pointing to use options for cash flow generation, also known as “derivative income” strategies, or more commonly, covered call strategies.
In practice, covered calls are traditionally formed as an overlay on an existing portfolio and can be constructed to focus on more defensive, S&P 500-type stocks that generate cash flow and select specific options to form an optimal risk-return covered call portfolio.
But here’s what’s really important: A covered call program can potentially work in any type of market, including ultra-volatile markets like the one we’ve been experiencing. Overlays are a very nimble strategy and can be adjusted to current conditions by selling further out-of-the-money calls with an eye toward appreciation of underlying equities should the market bounce. Nothing’s perfect, but in the end, experience tells us that selling call options when selected optimally not only reduces risk but can also benefit the expected return.
INSTITUTIONAL HAS BECOME RETAIL
Even just a few years ago, sophisticated covered call products were considered a niche category, offered primarily to institutional investors as a way to hedge risk and generate cash flow. In recent years, however, the category has exploded, and financial advisors have increasingly begun integrating the benefits of covered call writing into individual investor portfolios.
How big has the explosion been? According to the CBOE, assets in option-based strategies, which can now be accessed through ETFs, mutual funds, and separately managed accounts, have grown nearly eightfold since 2019, jumping from $20 billion to over $160 billion.
RETHINKING ALLOCATIONS
While the level of correlation between equities and fixed income appears to have changed over time, a core bond allocation will always play a crucial role in a well-managed portfolio. That role, however, is evolving, especially in today’s market. So, to answer our question earlier: Yes, this really is a time for asset allocators to consider a potentially important strategic reallocation to the traditional 60/40 portfolio.
In a recent whitepaper, the CBOE indicates that the hypothetical 60/20/20* has outperformed the traditional 60/40 portfolio in 13 of the past 19 years. The alternative portfolio has also done better in recent years, with a higher Sharpe ratio vs. the traditional 60/40 portfolio in each of the past four years.
Bottom line: There’s good reason advisors and investors have turned to covered call strategies to help manage portfolio risk. This allocation – even a small one – can work.
Nick Griebenow, CFA, is a portfolio manager for the Shelton Equity Income Fund (EQTIX).
*60% stocks, 20% bonds, and 20% in a call overwriting strategy.
Important Information:
Options involve risk and are not suitable for everyone. Prior to buying or selling an option, your client must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS.
Investments in derivatives may be risker than other types of investments. They may be more sensitive to changes in economic or market conditions than other types of investments. Many derivatives create leverage, which could lead to greater volatility and losses that significantly exceed the original investment. Positions in equity options can reduce equity market risk, but can limit the opportunity to profit from an increase in the market value of stocks in exchange for upfront cash as the time of selling the call option. Unusual market conditions or the lack of a ready market for any particular option at a specific time may reduce the effectiveness of option strategies and could result in losses. Investors can lose premium paid to purchase the option if it is not exercised.
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