Prologue
While the song ‘Bye Bye Bye’ was a much-loved hit at the turn of the century, over time, NSYNC ultimately evolved into its most efficient form: a solo Justin Timberlake. Perhaps it is time for index buywrite strategies to be viewed with a similar loving nostalgia as allocators say goodbye and move on to a more durable, efficient form going forward, i.e. the index putwrite.
* In a buywrite strategy an investor owns an equity index and sells/writes a call option on the index. Commonly referred to as a covered call strategy.
Chapter 1: The Beginning
Once upon a time, writing/selling call options on equity indexes seemed to offer investors an opportunity to achieve the impossible. By simply selling away a portion of the upside potential of the equity index position, they could potentially reduce their portfolio volatility by collecting an upfront cashflow, i.e. generate income, and at the same time, earn a higher return than the underlying index. Ironically, this is not a portfolio management industry fairytale. To the contrary, over the last few decades billions of dollars have been invested in option strategies that sell away portions of equity index upside return potential, i.e. call writing. While the S&P 500 Index BuyWrite Strategies captured the vast majority of flows, our comments also apply to other option strategies that sell/write index call options like collars and condors.
The chart below illustrates the excess return and volatility reduction of the CBOE S&P 500 30-Delta BuyWrite Index and the CBOE S&P 500 2% Out-of-the-Money BuyWrite Index versus the S&P 500 Index from each of their inceptions up until 10 years ago (July 31, 2010).
Past Performance Is Not…
Index Inception – July 31, 2010
Chapter 2: Too Good to be True
The data tells a very compelling story. An investor would have earned 1 – 2% more than the S&P 500 Index per year with a 2 – 2.5% reduction in annual volatility. Ever meet an investor who doesn’t like more return for less risk? We haven’t either. Yet, as one might expect, the last decade has served as a closing act for the S&P 500 BuyWrite Strategy. Fortunately for investors, unlike some option strategy endings, this story is not a Shakespearean tragedy. Rather, it has been more of a ‘fade to black’. The chart below provides the same statistics as above for the last decade. In short, S&P 500 BuyWrite Strategies continued to reduce volatility, but they have forfeited a significant portion of portfolio capital appreciation. Underperforming the S&P 500 Index, which annualized at 13.8%, by more than 450bps per year is well beyond most investor limits.
...Indicative Of Future Results
July 31, 2010 – July 31, 2020
Chapter 3: The Implied Volatility Premium
The fading of the buywrite excess returns naturally raises questions about the supposed vanishing of the S&P 500 Index implied volatility premium over the past 10 years. Yet, the decline in buywrite strategies only tells half the story of the implied volatility premium. The chart below plots the implied volatility premiums for S&P 500 Index put and call options.
Two Sides To Every Story
July 31, 2010 – July 31, 2020
Source: CBOE, Bloomberg LP. Implied volatility premiums are estimated based data sourced from Bloomberg and standard option price calculations. Premium yields are calculated as the option premium divided by the option strike price.
The right-hand side of the chart affirms the decline in S&P 500 buywrite excess returns with zero-to-negative implied volatility premiums earned for selling out-of-the-money call options. To be clear, this does not mean that call sellers have not collected cash upon selling the option; it just means that without an ‘overpayment’ for selling that option, the seller would have likely been better off moving to cash to de-risk instead of selling the call option. Considering that S&P 500 BuyWrite Strategies are supported by investors that hold positions in the S&P 500 Index, we believe an efficient equity marketplace will not allow long-term investors to earn higher returns in exchange for accepting less risk relative to the underlying equity index (recall charts in previous section). Basically, option markets have evolved in the last decade. They have become wise to ‘unjustified’ excess returns once earned by call sellers and have adjusted the ‘pricing’ accordingly, at least in part due to the dramatically increased access to the option marketplace. Once an esoteric playground for PhDs, acceptance and knowledge about the use of options has grown to the point where any retail investor long the market can now partake in the options market.
Chapter 4: Shorting Volatility or Equity Markets?
Over the years, we have found most investors do not view buywrite strategies as explicitly ‘short vol’ strategies. Whereas, putwrite2 strategies are commonly considered the riskier sibling that ran off to live in short vol city. However, when we decompose the put/call writing/selling into their two basic exposures (table below), we find many investors begin to change their perspective.
2 Strategy in which an investor sells/writes a put option on an index and holds collateral in cash or cash-equivalents.
If we assume the short volatility exposures of the put and call options are roughly equivalent, which is a stretch given our previous illustration, then the only difference to consider is their directional exposure to the underlying index. In put writing, an investor sells volatility but remains long the underlying index. In selling the call option, the investor similarly sells volatility but becomes short the underlying index. Does it make sense for any long-term investor to be short the right-tail of the S&P 500? Of course not, we believe, and this is why a buywrite strategy holds the underlying index to limit that inherent upside risk of selling the call. An investor should ask themselves if it is prudent to be both long and short the index in an attempt to gain access to a volatility premium that is negligible at best when sourced through call selling. Perhaps there is a better ending to this internal conflict.
Chapter 5: Re-Writing this Tale
Philosophically, we believe investors own equity index exposure for the upside participation, i.e. right-tail, and therefore should not sell a portion of it away in exchange for a modest call option premium. However, since an out-of-the-money buywrite strategy is simply a mix of an option premium and index beta exposure, a blend of a putwrite strategy and the underlying passive index exposure can be used to approximate risk-equivalent out-of-the-money buywrite strategies.
More specifically, a blend of a putwrite strategy with passive S&P 500 Index exposure can replicate a similar risk profile as popular out-of-the-money buywrite indexes, including the CBOE S&P 500 30-Delta BuyWrite Index and the CBOE S&P 500 Zero-Cost Put Spread Collar. Blending a putwrite with beta 1.0 exposure can produce a potentially superior long-term return due to the ‘unencumbered’ upside that is preserved by owning the S&P 500. The better up-market capture of the blend has potential to add value over time as periods of sharp reversals can erode the efficiency of selling call options (upside). Again, the efficiency of blending short put option premiums, collateral income and S&P 500 exposure has produced a more efficient equity exposure than the combinations of S&P 500 and short call option premiums.
Re-writing Portfolio Allocation
July 31, 2010 – July 31, 2020
1 Returns are based on representative composite account(s) monthly gains/losses for fully collateralized put options for indicated index exposure. Representative account data weighted by account notional exposure and is modified to reflect collateral assumed to be held in short-term U.S. Treasuries. Actual collateral of representative account differs and if such actual collateral was reflected returns shown would have been higher. Return estimates include transaction costs. Returns are presented on a supplemental basis and are based upon the applicable index component (S&P 500) of representative fully collateralized NB Global PutWrite Equal Weight (ATM) composite account(s). No one received this representative account model performance from the period of 2011 – 2017 since it was managed part of a larger strategy and not as a stand-alone strategy. From 2017 – present the representative account was managed as an actual strategy whose performance is presented at the end of this presentation as the S&P Index PutWrite (ATM) Composite. Past performance is no guarantee of future results. Please refer to the attached GIPS® compliant composite presentation for complete performance information. All returns are gross of fees. Gross of fee returns do not reflect the deduction of investment advisory fees, trading cost or any other expenses. If such fees and expenses were reflected, returns referenced would be lower. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Blended returns are rebalanced monthly and are gross of fees. Investing entails risks, including possible loss of principal. See Additional Disclosures at the end of this piece, which are an important part of this presentation.
A Happier Ending
Based on our discussions with investors, we believe making smaller allocations to an index putwrite strategy and combining it with a passive equity index exposure—in some cases ‘delta’ completion to target a specific beta to an equity index—is preferable to committing a larger allocation to an equity index buywrite strategy. Maximizing the lower-cost passive index exposure helps to maintain a lower aggregate fee structure, to preserve a greater degree of full right-tail exposure to an equity index and to limit the overall allocation to option strategies at the portfolio level, which reduces a portfolio’s dependence on option premiums—all of which should resonate with allocators.
Appendix – Global Index Putwrite (ATM) Composite
Annualized Rates of Return – As of June 30, 2020
Periods less than 1 year are not annualized.
Past performance is no guarantee of future results.
Please see attached important disclosures which contain complete performance information and definitions.
Investment Performance Disclosure Statement
Compliance Statement
Neuberger Berman Group LLC (NB, Neuberger Berman or the Firm) claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS® standards. Neuberger Berman has been independently verified for the period January 1, 2011 to December 31, 2018. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS® standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS® standards. The NB Global Index PutWrite (ATM) composite has been examined for the periods January 1, 2017 to December 31, 2018. The verification and performance examination reports are available upon request.
The GIPS® firm definition was redefined effective January 1, 2011. For prior periods there were two separate firms for GIPS® firm definition purposes and such firms were independently verified for the periods January 1, 1997 to December 31, 2010 and January 1, 1996 to December 31, 2010, respectively.
Definition of the Firm
The firm is currently defined for GIPS® purposes as Neuberger Berman Group LLC (NB, Neuberger Berman or the Firm), and includes the following subsidiaries: Neuberger Berman Investment Advisers LLC, Neuberger Berman Europe Ltd., Neuberger Berman Asia Ltd., Neuberger Berman East Asia Ltd., Neuberger Berman Singapore Pte. Ltd., Neuberger Berman Taiwan Ltd, Neuberger Berman Australia Ltd., Neuberger Berman Trust Company N.A., Neuberger Berman Trust Company of Delaware N.A., NB Alternatives Advisers LLC and Neuberger Berman Breton Hill ULC.
Policies
Policies for valuing portfolios, calculating performance and preparing compliant presentations are available upon request.
Composite Description
The Global Index PutWrite (ATM) Composite (the Composite) includes the performance of all fee-paying Global Index PutWrite (ATM) portfolios, with no minimum investment, managed on a fully discretionary basis by the Option Group. The Global Index PutWrite (ATM) strategy sells at-the-money puts across U.S., Developed and Emerging markets. Options are fully collateralized by a fixed income portfolio predominantly consisting of short duration Treasuries. The strategy seeks to both increase long term return potential and reduce investment volatility. Underlying index exposures are selected consistent with client asset allocations, and risk parameters are set with client’s risk/return objectives. Collateral investments reflect investor preferences and are managed with an emphasis on capital preservation. Option exposure is managed to increase diversification across tenors and strike prices and reduce downside risk from high delta option positions during down markets. Option positions with little remaining time values can be rolled to collect additional premiums and increase capital efficiency. The Composite was created in September 2017 and the performance inception date is March 2011. From March 2011 to September 2017, the performance track record is the performance of the Global PutWrite Equal Weight (ATM) composite. The Global PutWrite Equal Weight (ATM) composite represented the performance of all fee-paying Global PutWrite Equal Weight (ATM) strategy accounts managed by the Option Group on a fully discretionary basis regardless of market value. The Global PutWrite Equal Weight (ATM) strategy sold at-the-money puts with notional exposure equally weighted across U.S., EAFE and EM markets. The composite was created in January 2016. The performance history of the composite prior to January 1, 2016 was comprised of the performance history of the accounts managed by the portfolio management team while at a predecessor firm. A complete list of Neuberger Berman’s composites is available upon request.
Primary Benchmark Description
The benchmark is a Custom Blend. The blend consists of 50% CBOE S&P 500 PutWrite Index, 35% CBOE MSCI EAFE PutWrite Index, and 15% CBOE MSCI Emerging Markets PutWrite Index. The blend is rebalanced monthly and is calculated on a total return basis. The Cboe S&P 500 PutWrite Index measures the performance of a hypothetical portfolio that sells S&P 500 index (SPX) put options against collateralized cash reserves held in a money market account. The put strategy is designed to sell a sequence of one-month, at the money, S&P 500 Index puts and invest cash at one and three month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts. The CBOE MSCI EAFE PutWrite Index is designed to track the performance of a hypothetical passive investment strategy that collects option premiums from writing an At-the-Money (ATM) MXEA Put option on a monthly basis and holds a rolling money market account invested in one-month T-bills to cover the liability from the short MXEA Put option position. The index is a total return index that is rebalanced monthly. The CBOE MSCI Emerging Markets PutWrite Index is designed to track the performance of a hypothetical passive investment strategy that collects option premiums from writing an At-the-Money (ATM) MXEF Put option on a monthly basis and holds a rolling money market account invested in one-month T-bills to cover the liability from the short MXEF Put option position. The index is a total return index that is rebalanced monthly.
Reporting Currency
Valuations are computed and performance is reported in U.S. Dollars. Performance includes reinvestment of dividends and other earnings.
Fees
Composite Gross of Fee returns are the return on investments reduced by any trading expenses incurred during the period. Composite Net of Fee returns are the Gross of Fee returns reduced by investment advisory fees.
Fee Schedule
The annual investment advisory fee, generally payable quarterly, is as follows: 0.65% on the first $50mn; 0.55% on the next $50mn; 0.45% thereafter.
Internal Dispersion
Internal dispersion is calculated using the asset-weighted standard deviation of annual gross returns of those portfolios that were in the Composite for the entire year. Internal dispersion is not calculated if the Composite does not contain at least 6 portfolios for the entire year.
Annualized Standard Deviation
The three-year annualized standard deviation measures the variability of the Composite and the benchmark returns over the preceding 36-month period. The standard deviation is not required for periods prior to 2011.
Additional Notes and Disclosures
As of December 2019, the composite primary benchmark changed from a custom blend of 50% ICE BofA 0-3 Month U.S. Treasury Bill Index/16.67% S&P 500 Index/16.67% MSCI EAFE (Net) Index (Europe, Australasia and Far East)/16.66% MSCI Emerging Markets (Net) Index to a custom blend of 50% CBOE S&P 500 PutWrite Index, 35% CBOE MSCI EAFE PutWrite Index, and 15% CBOE MSCI Emerging Markets PutWrite Index as the investment team believes the updated benchmark blend more appropriately reflects the composite investment strategy.
Appendix – S&P Index Putwrite (ATM) Composite
Annualized Rates of Return – As of June 30, 2020
Investment Performance Disclosure Statement
Compliance Statement
Neuberger Berman Group LLC (NB, Neuberger Berman or the Firm) claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS® standards. Neuberger Berman has been independently verified for the period January 1, 2011 to December 31, 2018. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS® standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS® standards. The NB Global Index PutWrite (ATM) composite has been examined for the periods January 1, 2017 to December 31, 2018. The verification and performance examination reports are available upon request.
The GIPS® firm definition was redefined effective January 1, 2011. For prior periods there were two separate firms for GIPS® firm definition purposes and such firms were independently verified for the periods January 1, 1997 to December 31, 2010 and January 1, 1996 to December 31, 2010, respectively.
Definition of the Firm
The firm is currently defined for GIPS® purposes as Neuberger Berman Group LLC (NB, Neuberger Berman or the Firm), and includes the following subsidiaries: Neuberger Berman Investment Advisers LLC, Neuberger Berman Europe Ltd., Neuberger Berman Asia Ltd., Neuberger Berman East Asia Ltd., Neuberger Berman Singapore Pte. Ltd., Neuberger Berman Taiwan Ltd, Neuberger Berman Australia Ltd., Neuberger Berman Trust Company N.A., Neuberger Berman Trust Company of Delaware N.A., NB Alternatives Advisers LLC and Neuberger Berman Breton Hill ULC.
Policies
Policies for valuing portfolios, calculating performance and preparing compliant presentations are available upon request.
Composite Description
The S&P Index PutWrite (ATM) Composite (the Composite) includes the performance of all fee-paying S&P Index PutWrite (ATM) accounts with no investment minimum managed on a fully discretionary basis by the Option Group. The S&P Index PutWrite (ATM) strategy sells at-the-money puts with notional exposure to the S&P 500 Index. Options are fully collateralized by a fixed income portfolio predominantly consisting of short duration Treasuries. The strategy seeks to both increase long term return potential and reduce investment volatility. Underlying index exposures are selected consistent with client asset allocations, and risk parameters are set with client’s risk/return objectives. Collateral investments reflect investor preferences and are managed with an emphasis on capital preservation. Option exposure is managed to increase diversification across tenors and strike prices and reduce downside risk from high delta option positions during down markets. Option positions with little remaining time values can be rolled to collect additional premiums and increase capital efficiency. The Composite was created in February 2017 and the performance inception date is March 2017. A complete list of Neuberger Berman’s composites is available upon request.
Primary Benchmark Description
The benchmark is a Custom Blend. The blend consists of 50% CBOE S&P 500 PutWrite Index and 50% CBOE S&P 500 One-Week PutWrite Index. The blend is rebalanced monthly and is calculated on a total return basis. The CBOE S&P 500 PutWrite Index measures the performance of a hypothetical portfolio that sells S&P 500 index (SPX) put options against collateralized cash reserves held in a money market account. The put strategy is designed to sell a sequence of one-month, at the money, S&P 500 Index puts and invest cash at one and three month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts. The CBOE S&P 500 One-Week PutWrite Index is designed to track the performance of a hypothetical strategy that sells an at-the-money (ATM) S&P 500 Index (SPX) put option on a weekly basis. The maturity of the written SPX put option is one week to expiry. The written SPX put option is collateralized by a money market account invested in one-month Treasury bills. The Index rolls on a weekly basis, typically every Friday.
Reporting Currency
Valuations are computed and performance is reported in U.S. Dollars. Performance includes reinvestment of dividends and other earnings.
Fees
Composite Gross of Fee returns are the return on investments reduced by any trading expenses incurred during the period. Composite Net of Fee returns are the Gross of Fee returns reduced by investment advisory fees.
Fee Schedule
The annual investment advisory fee, generally payable quarterly, is as follows: 0.45% on the first $50mn; 0.40% on the next $50mn; 0.35% thereafter.
Internal Dispersion
Internal dispersion is calculated using the asset-weighted standard deviation of annual gross returns of those portfolios that were in the Composite for the entire year. Internal dispersion is not calculated if the Composite does not contain at least 6 portfolios for the entire year.
Annualized Standard Deviation
The three-year annualized standard deviation measures the variability of the Composite and the benchmark returns over the preceding 36-month period. The standard deviation is not required for periods prior to 2011.
Additional Notes and Disclosures
As of June 2020, the composite primary benchmark changed from the CBOE S&P 500 Putwrite Index to a custom blend of 50% CBOE S&P 500 Putwrite Index/50% CBOE S&P 500 One-Week PutWrite Index, as the investment team believes the updated benchmark more appropriately reflects the composite investment strategy.
Appendix – Index Descriptions
The CBOE S&P 500 2% OTM BuyWrite Index (BXY) uses the same methodology as the widely accepted CBOE S&P 500 BuyWrite Index (BXM) but the BXY Index is calculated using out-of-the-money S&P 500 Index (SPX) call options, rather than at-the-money SPX call options.
The CBOE S&P 500 30-Delta BuyWrite Index (BXMD) is designed to track the performance of a hypothetical covered call strategy that holds a long position indexed to the S&P 500 Index and sells a monthly out-of-the-money (OTM) S&P 500 Index (SPX) call option. The call option written is the strike nearest to the 30 Delta at 10:00 a.m. CT on the Roll Date.
The CBOE S&P 500 Zero-Cost Put Spread Collar Index (CLLZ) is designed to track the performance of a hypothetical option trading strategy that 1) holds a long position indexed to the S&P 500 Index; 2) on a monthly basis buys a 2.5% - 5% S&P 500 Index (SPX) put option spread; and 3) sells a monthly out-of-the-money (OTM) SPX call option to cover the cost of the put spread.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value. The 500 is one of the most widely used benchmarks of U.S. equity performance. As of September 16, 2005, S&P switched to a float-adjusted format, which weights only those shares that are available to investors, not all of a company’s outstanding shares. The value of the index now reflects the value available in the public markets.
