Throughout the 1990s and 2000s, institutional investors were generally short term buyers of options, and the desire for protection only intensified after the crisis. But as the U.S. bull market dragged on, the poor performance of those tactics led to institutions flipping to the other side of the trade, in particular through call-overwriting strategies.
“Ultimately, where we got to is a simple idea: Instead of owning a lot of risk and hedging, why not own less and be a seller of the thing you say is so expensive and complex?” said Thomas Lee, managing director of investment strategy at Parametric Portfolio Associates, which runs short-options strategies for clients including endowments, foundations and pensions.
The problem is excessive selling may have worn down the premium so much that it has deflated returns, creating pockets of leverage when firms try to compensate. These are prone to blow-ups, such as the one suffered by the Catalyst Hedged Futures Strategy Fund in 2016 and 2017.
“Like with many popular investing approaches that become very well-known and utilized, the question is what is the trade-off between scale and how well they can be expected to perform in the future,” QVR’s Eifert said. “Our view is we’ve tipped over that point where future returns won’t be as promising given the flow of capital into the space.”
It’s notoriously hard to pin down the size of the short-volatility trade. Sanford C. Bernstein strategist Ethan Brodie says it’s “alive and well,” though ever-shifting in nature. With ETPs having shed most of their assets in the past 18 months, much of the exposure now resides in the murkier institutional market in the form of over-the-counter instruments like options and swaps, Brodie wrote in an August note.
Proponents of the strategy say any challenges are cyclical rather than structural in nature; a function of the enduring low-volatility backdrop created by unprecedented central bank accommodation. And rumors about the death of the trade haven’t stopped practitioners like Parametric. The firm continues to recommend selling a combination of out-of-the-money calls and cash-collateralized puts in order to smooth the expected returns of an equity portfolio.
“The volatility risk premium is like any other risk premium,” Lee said. “It will ebb and flow over time.”
Skew Survives
The thinking goes that income received from selling the contracts provides a cushion against drawdowns, while clipping some potential gains. Parametric’s team closely monitors how its trades are digested by the market to get a qualitative understanding of how its activity may be influencing returns, Lee said.
At Analytic Investors, a division of Wells Fargo Asset Management running $700 million in options strategies, Megan Miller also maintains that the market still favors contract sellers. The presence of skew still exists, which tells the portfolio manager that demand for protection remains.