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Put Protection: Worth Your Left Arm?
By: Anthony M. Novara, CFA, Research Director
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| With equity markets hitting increasingly new highs, investors may wonder if a market downturn is on the horizon, as well as the potential for unimpressive future returns. These concerns come with plenty of merit as ample evidence exists that the valuation of the market is a key determinant of future returns. Exhibit 1 highlights the inverse relationship between the beginning valuation of the S&P 500 Index and the subsequent 10-year real return.
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| Source: Morningstar, Robert Shiller data, DiMeo Schneider & Associates, L.L.C. Analysis
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Given the potential for lower future U.S. equity returns over the intermediate term, coupled with the imperfect ability to predict the future, investors are left with three options to mitigate downside risk:
1. Remain invested, prudently rebalance between asset classes and expect that long-term returns (greater than 10 years) will be unaffected by any downturn that impacts shorter term returns.
2. Revisit your objectives and potentially modify the asset allocation strategy, which may include trimming U.S. equities and increasing fixed income and hedge funds or holding cash with the proceeds, all of which have historically protected capital better in down markets. Given today’s historically low yields and credit spreads, fixed income may not appeal to many investors either.
3. Purchase downside protection in the options market by owning put options that benefit from falling prices and insulate an investor from a downturn.
The basic mechanics of a put option are relatively straightforward: an investor pays a premium at inception and in exchange, receives the right (but not the obligation) to exercise the option if the price of the reference asset (in this case, the S&P 500 Index) falls below the initially agreed upon strike price. Option contracts generally have terms within one year, so once expired, contracts must be rolled to keep the exposure in place. The strike price can either be “at-the-money” (ATM), which indicates the strike price reflects today’s current price, or “out-of-the-money” (OTM), which might be 10% or 20% lower than today’s price. In the example of 10% OTM, an investor would have to withstand a 10% loss before the put options became profitable and began to offset further losses. In exchange for the premium, the investor is protected on the downside and has low maximum loss as the put buyer can only lose his/her initial premium payment. As expected with any financial market, protecting against even greater loss entails a higher expense and thus, ATM puts have more expensive upfront premiums than 10% OTM puts, and 20% OTM puts have the lowest initial premiums.
In theory, put options sound like a viable strategy in today’s market that is rightfully concerned about the higher perceived potential for a market downturn. After all, an upfront payment to protect against future poor outcomes is the core business model of the entire insurance industry. However, like many things in a market-based economy, price matters a great deal. In the case of buying put options outright over a long period, the costs are considerable and add up quickly over time. Exhibit 2 displays the initial cost of historical put premiums at the beginning of each calendar year.
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Given the substantial cost of purchasing put options on a long-term basis, quantifying the initial benefit of better downside protection before and after these costs can help investors determine the long-term benefits of owning put options. As illustrated in Exhibit 3, 10% and 20% OTM puts have before cost return benefits of +2.7% and +1.4%, respectively, per year. If investors were able to acquire these options free of cost, owning them would be a no-brainer. Unfortunately, the annualized costs of -4.2% and -2.3% for 10% and 20% OTM puts, respectively, more than offset the before cost benefits and leave the investor with worse returns by -1.6% and -0.9% annualized versus buying and holding a simple S&P 500 allocation over the same period. In addition, the protection becomes significantly more expensive after a downturn. In January 2007, 10% OTM puts sold for a cost of -1.8% when sentiment was high. Conversely, in January 2009, the cost rose to -9.9% in the aftermath of the financial crisis. In this case, the -9.9% cost was even worse since it offset a good portion of the +26.5% rebound in that year. Lastly, the “hit rate” of buying puts has been extremely low. Over the last 24 years, 10% OTM puts have only paid off in four total calendar years or about 17% of the time. 20% OTM puts have only been profitable 8% of the time or in two calendar years. Investors generally balk at paying for assets that hardly ever pay off.
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Source: Morningstar, Parametric, DSA Analysis. Put options trade on the movement in the Price Change index, which excludes dividends.
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Source: Morningstar, Parametric, DSA Analysis
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Continually hedging doesn’t make economic sense in our view. For investors concerned about their domestic equity portfolio, we believe a larger allocation to downside volatility mitigating asset classes like cash, bonds or hedge funds produces similar return results as put protection without the excessive cost. Exhibit 4 highlights similar drawdown profiles and long-term results for the two put protection strategies as compared to divesting 30% of the allocation and investing in the Barclays Aggregate, T-bills or hedge funds instead. While there is some variation, any of these three scenarios achieve similar outcomes without paying the extremely high annual costs necessary for a systematic put protection strategy. Ultimately, mitigating downside risk is most easily addressed when assessing and quantifying an investor’s objectives.
Please contact any of the professionals at DiMeo Schneider & Associates, L.L.C. to review your overall asset allocation strategy and evaluate potential risk mitigators.
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aThis analysis uses Robert Shiller’s publicly available data for beginning of period Cyclically Adjusted Price to Earnings ratios for the S&P 500 (http://www.econ.yale.edu/~shiller/data/ie_data.xls). In addition, Morningstar (formerly Ibbotson) provides access to S&P 500 returns that begin in 1926. The rolling 10-year annualized total return was calculated for each period starting in 1935 and rolled forward every month while pairing each 10-year return with its beginning of period Shiller P/E. Lastly, Ibbotson’s inflation series were subtracted from each monthly nominal total return to arrive at real (net of inflation) total returns for each rolling 10-year period.
b Put option prices are captured at the beginning of each year and assumed to be held for a one- year term.
c10% OTM puts would generate a profit and insulate the investor from any further downside after the price change in the S&P 500 is worse than -10% in a given calendar year. The before cost adjusted return assumes a -10% return (or -20% for 20% OTM puts) for the investor when the price return is worse than -10% (or -20% for 20% OTM) in a calendar year and adds back the income return from dividends. The adjusted return after costs columns take the initial adjusted returns and subtract the corresponding annual costs columns. The costs displayed include the initial premium paid for the options but exclude transaction costs and market impact (if any). Put options went “in-the-money” in 2000, 2001, 2002 and 2008 for 10% OTM puts and 2002 and 2008 for 20% OTM puts. These calendar year returns are denoted in blue.
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| While this article addresses generally held investment philosophies of DiMeo Schneider & Associates, L.L.C., it does not represent a specific investment recommendation for any individual client or prospective client. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Any forecast represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance does not indicate future performance.
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| This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any dissemination or distribution is strictly prohibited.
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