Rebalancing Using Options March 2014 SIGLO Capital Advisors AG | - PowerPoint PPT Presentation

SIGLO Capital Advisors AG Rebalancing Using Options March 2014 SIGLO Capital Advisors AG | Birmensdorferstrasse 140 | CH-8003 Zurich | Switzerland Phone: +41 44 576 40 76 | Fax: +41 44 576 40 73 | contact@siglo.ch | www.siglo.ch

Agenda • Blends / Assemblage • Option-writing • Rebalancing • Strategic asset allocation of Swiss institutional investors • What we did in our paper • We found a fine blend but there might be even better ones 2014 CBOE Risk Management Conference 3

Blends – or as the Swiss say “Assemblage” Assembling and blending existing pieces and smart ideas can lead to great results Top French wines “assemble” up to 20 grapes Picasso and others “assembled” pictures Steve Jobs “assembled” technological ideas at Apple 2014 CBOE Risk Management Conference 4

Option-writing – Popular research branches and topics I Option pricing and valuation In the 60ies Ed Thorp trades options in a very smart way and discovers convertible arbitrage • The academics Fischer Black & Myron Scholes publish their thesis on option pricing in 1973 • Sheldon Natenberg has been describing ways how to trade volatility in practice for decades • VIX Robert Whaley and CBOE create the first volatility index in 1992 • Risk premium discussion Antti Ilmanen describes that selling volatility has on average generated positive returns • Nassim Taleb counters with Black Swans and argues to be long volatility • 2014 CBOE Risk 5 Management Conference

Option-writing – Popular research branches and topics II The implied volatility of stock markets 
 has often been higher than the realized volatility Other uses of options in the portfolio context: • Hedging exposures or bets • Generate alpha • Find uncorrelated returns 2014 CBOE Risk 6 Management Conference

Rebalancing I The Talmud advices to invest a third in each land, business and reserves Claude Shannon taught to rebalance on the stock market at MIT in the 60ies Benoit Mandelbrot’s fractals Stock prices and PE ratios tend to mean-revert over the last centuries, decades and also short-term 2014 CBOE Risk Management Conference 7

Rebalancing II 2014 CBOE Risk Management Conference 8

SAA of Swiss pension funds Institutional investors usually define a Average'Strategic'Asset'Alloca/on'of'Swiss'Pension'Funds' strategic asset allocation (SAA) 100.00%$ 90.00%$ 80.00%$ A SAA does not only contain 70.00%$ percentage points for allocations but 60.00%$ also lower and upper boundaries 50.00%$ 40.00%$ (constant proportion SAA) 30.00%$ 20.00%$ Boundaries are used to keep 10.00%$ 0.00%$ exposures constant over time 
 2004$ 2005$ 2006$ 2007$ 2008$ 2009$ 2010$ 2011$ 2012$ and his implies rebalancing Liquidity$and$Cash$ Bonds$ Equi=es$ Real$Estate$ All$Others$ Lower boundary Point Upper boundary 27% 30% 33% Equi%es ¡ ¡ ¡ ¡ ¡ ¡ ¡30% ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡100% ¡ Fixed ¡Income ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡50% ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡100% ¡ Real ¡Estate ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡20% ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡100% ¡ 2014 CBOE Risk Management Conference 9

Why we believe our assemblage to be interesting I If equity allocations increase more than 10% in If equity allocations fall more than 10% in the the SAA, investors sell equities and rebalance SAA, investors buy equities and rebalance the entire portfolio back to the original SAA the entire portfolio back to the original SAA Lower boundary SAA Point Upper boundary Equi%es ¡ ¡ ¡26% ¡ ¡ ¡27% ¡ ¡ ¡28% ¡ ¡ ¡ ¡ ¡ ¡ ¡30% ¡ ¡ ¡ ¡ ¡ ¡ ¡32% ¡ ¡ ¡33% ¡ ¡ ¡34% ¡ Sell puts with strike at boundary Capture the Sell calls with strike at boundary option premium 3% in SAA equals 15% OTM 3% in SAA equals 15% OTM if prices do not Buy equities at the price your Sell equities at the price your move beyond SAA asks you to buy anyway SAA asks you to sell anyway the boundaries Investors who aim for constant proportion exposure in the SAA get what they want anyway… …plus a potential premium from writing options! 2014 CBOE Risk 10 Management Conference

Why we believe our assemblage to be interesting II Systematize the rebalancing Avoid discretionary decisions under stress Avoid behavioral biases by forcing some discipline onto the rebalancing process Simple and straight implementation possible 2014 CBOE Risk 11 Management Conference

Methodology and Data • Base case SAA: 
 30% Equities 50% Government Bonds 20% Real Estate Asset Class Proxies 
 • S&P 500 TR Index Citigroup WGBI hedged in USD WUPIXF hedged in USD Options 
 • Traditional S&P 500 index options traded on CBOE (no LEAPs) 
 Always trade on bids and take full spread crossing 
 considering only non-zero bid options 
 take option trading fees into account 
 We always sold front-month options with “close-enough” strike and maturity 
 Options are fully collateralized by short-term US-Treasuries Assumption of using part of the bond allocation as collateral / margin • Assumption of having observable prices for all asset classes at hand to rebalance entire portfolio • and ability to trade all asset classes accordingly Observation Period is from January 1997 to December 2013 • 2014 CBOE Risk 12 Management Conference

Results and benchmark comparison I Ann. return Ann. volatility Return / Risk Max drawdown Base Case 6.83% 5.57% 1.23 16.27% Trigger-based (D) 6.85% 5.51% 1.24 15.99% Calendar-based (Q) 6.76% 5.44% 1.24 15.65% Buy-and-hold 6.43% 5.54% 1.16 15.18% Our base case: 
 Sell permanently 1-months call and put options with strike equal to the SAA rebalancing boundaries 3 Benchmarks to gauge the base case performance: Trigger-based (D): Rebalance instantly if boundaries are hit (maybe only possible with futures) • Calendar-based (Q): Rebalance at the end of every quarter if boundaries are hit • Buy-and-hold: Lean back and pray for market e ffi ciency • 2014 CBOE Risk 13 Management Conference

Results and benchmark comparison II Ann. return Ann. volatility Return / Risk Max drawdown Rulebased Implementation 6.93% 5.51% 1.26 15.27% Base Case 6.83% 5.57% 1.23 16.27% Trigger-based (D) 6.85% 5.51% 1.24 15.99% Calendar-based (Q) 6.76% 5.44% 1.24 15.65% Buy-and-hold 6.43% 5.54% 1.16 15.18% Can we do a little better? Yes, we can with a slightly smarter rulebased implementation Use multiple call and put options with di ff erent strike levels to smoothen the rebalancing • Use 3-months options instead of 1-months • There are certainly many more ways to improve, like steepness of the curve or…. 2014 CBOE Risk 14 Management Conference

Sensitivity analyses Other equity proxies • It works with SPX and MSCI World Index as equity proxies • It works great with 50-50 bond equity portfolios Other SAA • It works great with fixed real estate allocation Multiple strike levels • It works better using multiple options with di ff erent strikes Watch the shape of the curve • VIX level is a weak indicator but VXV-VIX is helpful Distance to SAA boundaries • Only write options if we are not too close to boundary Maturity • Writing 3-months options performs better than 1-month Other SAA boundaries • Wider or narrower boundaries work but less convincingly Collateral • Options are fully collateralized by short-term US-Treasuries 2014 CBOE Risk 15 Management Conference

We found a fine blend... Smart rebalancing using options…. …allows to capture more of the option premium …adds value if markets exhibit price reversals rebalancing using options… … implies counter-cyclical behavior and constant proportion SAAs that make sense for investors …systematizes the rebalancing …improves discipline in the process …lowers emotionally charged discussions …is pretty simple to implement Investors who aim for constant proportion exposure in the SAA get what they want anyway… …plus a potential premium from writing options! 2014 CBOE Risk 16 Management Conference

…but there might be even better flavors to be assembled Use multiple asset class underlyings for option-writing • Apply more granularity across underlyings • Enhance returns by exploiting the shape 
 • and the dynamics of the volatility curve Use options to express tactical views • Download the full paper on CBOE’s website 
 • 2014 CBOE Risk 17 Management Conference

For more information… SIGLO’s white paper, “Rebalancing Using Options”, will soon be available on the CBOE website. See http://www.cboe.com/3rdparty 2014 CBOE Risk 18 Management Conference

Your humble authors – another assemblage Dr. Christoph Gort � Emanuel Burgener � � � Partner � Head of Quantitative Research � SIGLO Capital Advisors AG � ecamos Investment AG � � � emanuel.burgener@ecamos.ch � cgort@siglo.ch � � � www.ecamos.ch � www.siglo.ch � 2014 CBOE Risk 19 Management Conference