With the exception of the 2008 financial crisis, the 60 percent stocks and 40 percent bonds/fixed income investment model has historically provided a great blend of equity growth and bond stability with attractive returns and low volatility. But fixed income valuations have become expensive, and their “stability” is no longer all that stable.
With interest rates hitting a floor and credit spreads tightening, it’s not hard to understand how the benefits derived from fixed income investing are waning. The days of fixed income securities serving as a let-you-sleep-at-night type of investment seem to be over for now.
Investors feeling a bit anemic and wanting meatier returns are being forced into a heavier equity allocation. That move, unfortunately, inherently increases a portfolio’s volatility. The Holy Grail for investors would be to achieve fixed income-like volatility while still being highly correlated to the equity markets, and an options strategy may be the key.
Although they have only recently begun to garner significant attention, options strategies are plentiful and have existed for a long time. The real benefit of options strategies in the current environment lies with their extreme flexibility and almost limitless creativity.
If investors buy Microsoft stock, they need Microsoft stock to go up in value. An options position, however, can be constructed in Microsoft that could benefit from Microsoft rising—or from Microsoft just sitting still, which creates more avenues from which to potentially profit. There are roughly 30 to 60 different options funds, depending on how the space is viewed, but all of them share the objective of producing a better risk adjusted return than is available from outright security ownership.
The key with options strategies is ensuring that an investor does not become levered, because although the leverage might amplify the return, the goal is to mute portfolio volatility, not gamble on higher returns.
Each options strategy incurs different risks, and consequently, each offers a different set of rewards. The most successful strategies are those with the greatest amount of flexibility, allowing option premiums to be captured when they’re attractive and keeping their exposure limited when they’re not.
This is not unlike long-only mutual fund managers who trade equities and try to buy the securities they think are cheap and sell those that have reached their growth targets. Option premiums work similarly to harness volatility, with premiums that can be monetized, sold and removed from the portfolio when they’re no longer attractive. When trading options, it’s important to focus on the hidden details to determine the actual yield. The advisor’s skill comes into play in deeming whether those premiums are attractive, just as a fixed income manager would decide whether a corporate bond was suitable for an investment.
Today’s economic environment has forced advisors to wake up to certain harsh realities, one of them being the traditional 60/40 allocation model’s irrelevance and inability to harness volatility in a way that truly helps investors. A growing number of advisors are adding options strategies to their client portfolios as a core allocation that addresses the rampant risk in today’s uncertain climate.