Be Wary of This Type of Option-Writing Fund

Tayfun Icten: Investors seeking diversified strategies to improve their portfolios' risk-adjusted returns consider funds in the option writing category, but this category does not have a uniform strategy.

In this chart, we rank ordered the funds with at least two years of track record according to their beta exposure to the S&P 500 index. As you can see in this chart, median beta exposure is about 0.5 with a wide dispersion of betas. A typical fund holds a long equity position, sells in-the-money calls (on the reference asset) to enhance yield in the portfolio, and buys out-of-the-money puts for some limited downside protection.

These funds fall in the middle of that chart with 0.3 to 0.6 beta. The risk/return trade-off often looks like a 60/40 portfolio, but there is no duration risk here. In fact, the option premium from selling calls improves with higher interest rates.

Academic studies suggest that in-the-money calls and out-of-the-money puts offer an excess volatility premium because of a skew in the implied volatilities, but disjointed markets following a vol spike--like happened in 2009--likely provide more profitable opportunities.

In this environment though, at the tail end of this business cycle, things do not look that rosy. Selling implied index volatility is not as attractive today, because equity volatility is trading at all-time lows, as indicated by the VIX index, and the short rates are still very low.

Investors should be particularly wary of low beta or negative beta funds in this category. Yes, they offer better diversification benefits, but some of them sell naked puts and calls aggressively to outperform their peers. These track records can look very attractive for a while with high income and high Sharpe ratios. But hidden tail risks can cause large unexpected losses during the next big spike in volatility. Margin to equity ratio is one of the good indicators of risk regarding these funds.

Option-based strategies are structured investments targeting a certain pre-defined risk/return trade-off. The best managers in this space stick to their disciplined and consistent process, stay away from selling excessive volatility, and avoid market-timing with options.