Taking the volatility out of equities

Vestiges of fear and uncertainty linger in the minds of many, however. Indeed, declines of the magnitude seen in late 2008 and early 2009 gave us all pause, and even though we have recovered some of that lost ground, the massive meltdown remains a stark reminder that the markets can be extremely volatile and remarkably unforgiving. It was a harsh message that left few untouched. It is likely that the financial and emotional scars left by this market turmoil have many investors saying to themselves: “There has to be another way — a way to increase our nest eggs and meet our financial goals without the gut-wrenching volatility that plundered our portfolios last year.” I think that this desire for a less stressful approach is probably most true among older and more conservative investors, many of whom are now seeking strategies that allow them to achieve higher risk-adjusted returns. They are looking for investment strategies that help mitigate some of the downside volatility of the equity market, while allowing them to remain invested in an asset class that historically has delivered long-term returns superior to those of the more conservative and less volatile fixed-income market, and thus providing a better potential hedge against inflation. Is this asking for too much? My experience suggests that it isn't. In fact, the use of equity options strategies has been shown to offer a successful approach for generating competitive equity returns with significantly diminished risk and lower volatility, especially when these strategies are structured as an overlay to an actively managed portfolio of stocks selected via fundamental research and analysis. Through the use of such derivatives strategies as index call options writing and put options buying, we have found that it is possible to reduce the volatility of an equity portfolio by as much as two-thirds while generating results that approximate the long-term mean annual return of the broader equity market. There are four individual components to this sort of investment strategy. At the center is a well-diversified, actively managed portfolio, generally focused on large-cap stocks with overall profiles similar to that of the S&P 500. Also key to such strategies are the tax management techniques used, where losses are harvested, and qualified-dividend income is sought in a directed effort to minimize short-term gains and avoid big tax bites. These are pretty standard investment approaches. Where it starts to get interesting is in the use of index options to adjust the portfolio's risk characteristics. To help rein in the overall volatility of a portfolio, one might consider adopting a methodology that comes, in part, from an academic study conducted in conjunction with the Chicago Board Options Exchange (“Return and Risk of CBOE Buy Write Monthly Index” by Professor Robert E. Whale, The Journal of Derivatives, Duke University Fuqua School of Business). The study found that by writing 30-day S&P 500 index call options at the money every month, one could earn the mean large-cap-equity-index return over time, but at only about two-thirds of the market's volatility. The premium income helps mitigate portfolio losses in a down market and augments portfolio returns that can be lessened by losses to counterparties if the market rises. An effective way to execute this component could be to write monthly index call options on a substantial portion of the portfolio, perhaps as much as 70% of its notional value. To take this example one step further, consider as well a program of purchasing index put options on the S&P 500 of six months in duration at 2% to 3% out of the money on about 100% of the portfolio's notional value. The put feature helps to reduce the volatility of the portfolio by about half again, which means that this two-tiered “buy-write” options strategy can actually diminish the overall portfolio volatility by as much as two-thirds. That remaining one-third of the normal volatility rate is roughly equivalent to the volatility of bonds relative to the equity market. Investment strategies such as this have the potential to deliver equitylike returns, with bond-like volatility. For generally risk-averse investors, such strategies may offer the peace of mind for which many investors are looking. Walter A. Row is the head of structured-equity portfolios for Eaton Vance Management.