Recently I read this article by Larry Swedroe on how after 2008 became really hard to invest in an hedge fund that will provide a meaningful overperformance (if any at all). HF were providing real alpha before that date and there is plenty of research (and movies and books…) to prove it: Billions is a great TV series on the topic because Season 5 became as stale as the real life performance of the characters it chronicles. As Swedroe writes, reasons are well known: the passive investing conversion reduced the pool of preys and competition between active managers became fiercer (paradox of skill).
The allure of the OG hedge funds was not limited to their alpha but also to their steady returns: in fact, they were called hedge for this exact reason, investment vehicles that could produce positive returns even when stock market indices were negative. The steady return baton might have passed to the cockroach portfolio type of managers but this style will have increased difficulties to produce high returns compared to a 100% stock benchmark. As we said, this strategy might be optimal for people that want to stay rich instead of having stellar performances.
The easiest (and at the same time hardest) way to achieve high returns is, as Sam Hinkie effectively put it, to take “the longest view in the room”. Some other participants in the market have constrains on this, they have career risk or they cannot psychologically sustains the ups and downs, so they create an opportunity for you. It is easy because you simply have to sit on your investments and do not touch them but it is also hard because you have to remain sane when everyone else is going mad.
The presence of these actors in the market, people that cannot stomach volatility and would pay an insurance premium to be insulated from it, opens the door to people that want to hold that specific risk. VerdadCap wrote a research piece on the efficacy and cost of hedging with options, where they explain how hard and/or expensive is to effectively hedge a stock portfolio from Black Swan events. Reading it I thought “what if I take the other side of that trade?”. In other words, what if I start my (small) insurance company?
Before you jump on your chair, this wants to be more a thought-provoking post that a practical guide on a strategy you should pursue.
Why this might not be viable
I did not run the back-test of the strategy on my side, so far I looked at the insurance-buyer side of the deal only from Verdad and others out there. The bid-ask spread might make both sides of the trade unattractive. The positive point here is that the insurance-buyer is forced to take whatever ask price is out there, they cannot sit on the bid and hope someone will hit because they have to hedge themselves. I can ‘provide liquidity’ and sit a bit under the ask in the book, if I do not get filled then it is more like a missed opportunity than anything else.
AIG, an insurance company, around 2007 thought that writing (i.e. selling) naked CDS could be a part of its core business: a CDS is an ‘insurance’ against a bond default and they believed to have the expertise to effectively manage this specific risk. Turned out the relying on Moody’s and pals AAA ratings was not a great way to assess risks and AIG run in some troubles, ultimately winning a bail-out from the US Government.
I am an idiot, or as Nassim Taleb would put it, an imbecile. I would not be surprised if there are some glaring (to others) aspects of this strategy that I am missing.
The strategy
Using plain vanilla put options to hedge market declines is path dependent. For example, let’s say I buys a 30% OTM put options each quarter. If the market falls less than 30%, the options will provide no protection. Therefore, when options are held to expiration, I need drawdowns to precisely coincide with my holding period to achieve maximum protection. This means that if I am on the other side of the trade, the probability of this option to expire ITM is less (way less) than the probability that the market will fall 30% in any 3 months timeframe.
Below graph from Verdad show the timing luck involved in rolling your option hedge at the end of a month compared to the middle of a month.
And this graph assume monthly rebalancing! If you ‘sell and hold’ your option only once per quarter, the chances of picking the wrong day are even lower.
Another encouraging element to hold the insurance risk is that options-based hedging seems to work best in black swan events, but only two such sharp and sudden drawdowns have happened in the past 50 years: Black Monday in 1987 and COVID-19 in 2020. And as Verdad notice: “We do not know if tail risk hedging would have worked in 1987 because of lacking data, but even if our hypothesis holds true, investors that hedged after Black Monday would have had to wait 33 years for their hedges to work again.“
The core of the strategy is simple: sell a 3 months, 30% OTM put on the S&P500 and hold it maturity. When it expires, repeat. On Bloomberg I can run a simple backtest, that unfortunately can go back only up to 2008, not really descriptive…
TILS Insurance Ltd
An important premise is in order: I read so much Taleb that I know estimating the probability of a Black Swan using only past event is very bad math. This strategy feels like picking up pennies in front of a steamroller and so far IT IS.
How do we make sure to stay away from the giant roller?
- Write an option on an underlying that has a positive expected return. I wrote in the past why selling puts on single stock is not a smart idea. I do not care about your ability as a stock analyst, if the information you are using are fake because the company insiders are cooking their books you are done without knowing it. The company you see when you sell the option might not be the same when you get called.
- Use the premiums to invest in something uncorrelated to the S&P500 and very liquid. You will need this reserve when your option expires ITM. You do not own the premiums until your reserve is around half the put option strike times the number of contracts under the put. It has to be uncorrelated because you do not want your reserve to depreciate when the S&P500 does. It has to be liquid because you do not know when the next Black Swan will happen. Yes, it means your reserve will have a yield close to the inflation rate if you are lucky, usually even lower. Plus, you will lose the cost of financing if you are using margin/leverage.
- Selling naked options is not ‘free’, you have to post margin so that your broker is sure that you have the money to pay the other side in case the option matures ITM. The cash you use as margin could have been invested somewhere else so there is a cost opportunity here.
At current prices, a 30% OTM put on the S&P500 will give you a gross yield of 20bps…not exactly the amount that will let you retire next year. All the issues you read around that fund that went busted, that other investor that got crushed are linked to the fact that greed pushes people to overextend and use too much leverage.
BUT
What if your portfolio is the classic 60/40? If the market plunges 30% or more, you will rebalance selling bonds and buying equities. In this sense, you already have your reserve, it is the 40 portion of the portfolio. This option strategy overlay will force you to do the rebalancing at a certain market target, the option strike price, instead of a certain point in time, your portfolio rebalancing date.
Which one of these two rebalancing plan generate the higher return depends on luck (unless you have the ability to point exactly at a market bottom). In some case, having a nudge that forces you to sell bonds and buy equities might be even beneficial.
And on top of that, you get the additional yield from the options premiums…or not? If we assume 0 correlation between bonds and equity, a 30% fall in equity means you have to move 7.2% of your total portfolio from bonds to equity. If you overlay the option strategy on that amount, at the end of the year your total return compared to a plain vanilla 60/40 strategy will increase by……..2bps! Gross of fees. I knew working for an insurance company sucks, now even creating one seems like a lousy deal 😉
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