Eaton Vance Hedged Equity Option Collar Strategy White Paper
Executive Summary
Investors weary of wealth destroying market corrections, also referred to as tail risk, have grown increasingly interested in the use of hedging strategies to protect their equity portfolios over the past decade. While the concept of hedged equity appears viable, creating an optimized, fully-hedged portfolio capable of providing enhanced returns over a full market cycle while dampening the impact of significant market corrections has proven difficult.
Seeking to provide investors with a solution addressing these issues, Eaton Vance introduced their Hedged Stock Fund in 2008. The fund utilizes a systematic, rules-based staggered collar option strategy intended to provide investors with a means to remain invested in the equity market over time, while seeking to reduce market risk and volatility.
This paper examines the challenge of tail risk, as well as its impact on investors. Common hedging strategies and their drawbacks are then reviewed. The Hedged Stock Fund’s systematic, rules-based staggered collar option strategy is then introduced and explained, with details on suitability, scenario analysis and limitations offered. Thereafter, the mechanics of the strategy are covered, ranging from the type of options utilized and frequency traded to the use of a volatility-based strike selection process.
Finally, the paper concludes that the Eaton Vance Hedged Stock Fund and its staggered collar option strategy is well suited to successfully address the issue of tail risk. It provides a viable solution allowing investors to participate in the equity market while being significantly protected. Most important to investors, the fund has rewarded shareholders with strong risk-adjusted returns that far outstrip those offered by investment in the S&P 500.
Introduction
Investors and their advisors generally desire, and in most cases need, some exposure within their portfolios to the U.S. equity market so they can participate in the upside returns historically afforded during bull market cycles. Yet many investors fear participation, recognizing they simply can’t afford to weather the effects of a severe market downturn.
The Eaton Vance Hedged Stock Fund EROIX was initially introduced in early 2008, with a focus on stock selection to generate alpha through a sector-neutral framework. The portfolio and hedges were designed to cost-effectively enable investors to capture a suitable amount of upside return, while seeking to reduce market risk and volatility.
The fund originally utilized a hedging strategy consisting of expensive, longer dated (6 to 9 month) S&P 500 Index puts and short term (1 month) S&P 500 Index calls. While the fund performed very well in the 2008 market pull back, it did not capture as much upside in the ensuing recovery as expected. Despite that, the fund did outperform the market by 18.66 percent during the 2008 to 2009 period.
The original approach was strategically altered in late 2012 to incorporate a systematic staggered collar option strategy utilizing “Out the Money” (OTM) options, which is believed to exemplify the core competencies of hedged equity investing, namely:
1. Use of a systematic, disciplined hedging strategy which does not rely on market timing to protect assets.
2. Minimizes hedging costs associated with buying market insurance by pairing short OTM calls and long OTM puts in a manner that fully funds the downside protection.
3. Maintains long-term commitment to equity investing by allowing for capital appreciation, protecting against tail risk and reducing overall portfolio volatility.
The current structure of the Eaton Vance Hedged Stock Fund has been in place for nearly four years. In that time there have bull markets – 2013, flat markets – 2015, and three market corrections – Nov 2014, Aug 2015 and Jan 2016. Throughout, the Hedged Stock Fund has maintained a commitment to always hedge 100 percent notional exposure and has performed as expected – especially during times of market volatility – rewarding shareholders with strong risk-adjusted returns.
Tail Risk Challenge
Most investors need to participate in the U.S. equity markets to help drive returns in their portfolios, but many are leery. They’ve witnessed the devastating effects that market sell-offs can have on a portfolio and have learned the hard way these events can take years and exponential upside returns from which to recover. (Fig 1 The Mathematics of Loss Chart)
That fear is merited, considering that corrections exceeding 20 percent, or bear markets, occur with frequency. According to Bloomberg, since 1929 there have been 25 bear markets, equating to an average of one every 3.4 years, lasting 10 months and experiencing a peak-to-trough drawdown of over 35 percent. (Chart -2.1)
Such extreme, unexpected, outside movements (either downward or upward) are referred to as “tail risk,” because they are outliers to what is considered a normal distribution, where the majority of market returns measured are centered about an “average” when illustrated on a Bell Curve. Left-tail or downward moves are typically characterized by a rapid market sell-off and a sharp spike in volatility, which can be extremely detrimental to a portfolio. (Fig 2 Bloomberg S&P 500 Actual and Expected Distribution Chart)
Frequently, left-tails immediately proceed “snapback” right-tail or sharp upward reversal events. Right tails have often offered the highest percentage of upside returns available over a short time period. (Fig 3 – EROIX 2008 to 2009 Chart)
History supports that such tail events occur more often and with greater magnitude than would be described by a normal or log-normal distribution, in periods of both high or low volatility. Investors have been left with the less-than desirable option of forgoing equity exposure altogether or forced to constantly maintain a hedge on their entire equity position – in most instances a costly endeavor.
Common Heading Strategies
Typical hedge strategies used to counter tail risk range from simple methods, such as buying quarterly and/or longer-term put options (very expensive), to market-timing models, and more sophisticated approaches – directional hedges using equity index options and volatility hedges underpinned by Variance or VIX options are both prime examples.
Widely used strategies and their respective drawbacks:
· Put Spread Collar: Best suited for moderate drawdowns. Drawback – the strategy requires the quarterly purchase of OTM (e.g.- 5 percent) puts. In the event of a meaningful market rise (e.g.- 8 percent) and subsequent reversal (e.g.- 5 percent), the hedge would effectively be negated until the next quarterly put option is purchased. Additionally, the strategy fails to solve for market volatility. Given the puts are purchased regardless the level of volatility, an investor could be forced to purchase very expensive put options after the market has already fallen.
· Collar: Provides adequate protection against left tail events. Drawback - requires the sale of at- the-money call options and the subsequent purchase of OTM put options, using a portion of the sale proceeds to fund the puts. Doing so effectively limits a portfolio’s return potential to the margin between the option sale and purchase transactions.
· Covered Call/Put Writing Strategy: Provides long-term hedge. Drawback – requires the purchase of one-year put options – very expensive. To mitigate the cost, the investor must actively manage the selling of short-term call and put options to capture offsetting premium, while avoiding hindering the long-term hedge (short term positions can render longer-terms hedges useless) or capping potential upside returns. Moreover, longer-term hedges are too expensive and their Gamma (measurement of option price change correlative to the change in price of the underlying asset) is too small to provide the full impact of hedge necessary if the market dislocates.
· VIX Calls: Used to offset an increase in implied volatility that would be expected during market declines. Drawback – while the relationship between equites and implied volatility is often correlative, that relationship has broken down in the past during times of market dislocation. In such times, a hedge utilizing VIX call options would not have worked in the intended manner.
Clearly there is a need for an efficient, cost-effective hedge strategy that is capable of dampening the devastating drawdown effect of a left tail event while maintaining exposure to the equity market. Such a strategy should allow for monetization and increased allocation at lower market levels, and be capable of capturing “higher percentage” right tail returns when available.
Staggered Collar Option Strategy
The Eaton Vance Hedged Stock Fund utilizes a systematic, rules-based staggered collar option strategy designed to dynamically adjust so the hedges may remain close in proximity to the relative market. The strategy employs the use of purchased S&P 500 Index OTM put options (generally 3 to 5 percent OTM), funded from the proceeds of S&P 500 Index OTM call options that are sold, creating a “costless” staggered series of option collars.
The hedge is applied across 100 percent of the portfolio and is designed to protect against left tail risk, reduce volatility, allow for increased equity allocation at lower market levels when puts are monetized, and provide the opportunity for suitable upside market returns.
Suitability: The Eaton Vance Hedged Stock Fund is best suited for:
· Retail and institutional investors who want to take some equity exposure “off the table,” given the tremendous upside of the past five years.
· Retail investors who missed the aforementioned move who now wish to capture any additional upside that may be available, but who fear the prospect of buying a “top.”
· Retail investors seeking to switch from a balanced approach between equities and fixed income to a more diversified combination of liquid alternatives, equities and fixed income.
· Retirees who still need to grow their assets, but can’t risk all their principle.
· Institutions who target an “X” percent risk-adjusted return.
Scenario Analysis: The Hedged Stock Fund would be expected to perform in the following manner for each market type:
· Strong Bull Market – may provide significant positive returns, but might underperform un- hedged equity strategies. Example – during the 2013 bull market, the Hedged Stock Fund produced a 16.69 percent return versus the 32.39 percent return on the S&P 500.
· Trending Bull Market – may perform in line with a traditional un-hedged equity strategy, given the upper band would never be breached. Example – the 2015 equity market. This would be considered the most optimal market profile for the fund.
· Flat Market – the underlying portfolio may drive the fund’s investment results and the options may provide little benefit relative to performance.
· Trending Bear Market –may perform in line with a traditional un-hedged strategy. Example – the 12 percent selloff in Jan 2016. Extremely unusual, with little volatility, tight trading ranges and daily moves limited to 2.5 percent and less. The market grinds down slowly, so no ability to monetize hedge or prudently increase allocation. This would be considered the least optimal market profile for the fund.
· Strong Bear Market – may experience limited declines relative to a traditional un-hedged strategy. Possibility of monetizing hedge, increasing allocation at lower market level and positioned to capture right tail returns in a snapback scenario. Example – the 2008 bear market (left tail), followed immediately by the 2009 v-shaped (right tail) upside recovery.
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Limitations: While the fund is intended to provide a guardrail approach to equity investing, allowing for market participation with protection against severe left-tail drawdowns exceeding 3 to 5 percent, the sacrifice of some upside potential is inherent.
Additionally, the strategy is designed based on past market downturns, intended to perform best in a market characterized by a rapid sell off that is accompanied with a quick spike in volatility. This strategy is not intended to protect against normally occurring 2 to 3 percent fluctuations.
Lastly, the strategy is not well suited for a market experiencing a slow-grinding selloff, coupled with low volatility. The protection afforded by the strategy is targeted directly to sharp selloffs. In a slow-grinding selloff scenario, the hedges won’t be monetized and the fund will therefore perform like an un-hedged portfolio.
Strategy Mechanics
The Trade: The systematic staggered-collar option strategy involves the sale of 28-day OTM call options providing income, coupled with the simultaneous purchase of 28-day OTM put options that require a premium to be paid. Combined, the two sets of options create a “costless” collar (premium received covers premium paid), providing downside portfolio insurance that acts as a floor on losses after the strike price of the protective put option is breached.
The below example is for illustrative purposes only: (insert image) S&P 500 is trading at 2060
· Buy April 2015 Put for 6.90 (downside capped to -2.2%)
· Sell April 2015 Call for 6.90 (upside capped to +1.2%)
*Strategy provides costless protection with defined upside and downside limitations.
Type of Options: The strategy utilizes 28-day options that expire on the 3rd Friday of each month. To avoid being tied to one specific expiration date (known as fixed-strike dependency), the strategy is designed to spread expiration risk throughout the month. This is accomplished through the use of a combination of highly liquid exchange-traded options, as well as CBOE traded Flex options that offer customized strike prices and maturities.
Frequency: The strategy is designed to ensure the portfolio remains 100 percent hedged throughout rolling one-month periods. To meet this objective, 1-month S&P 500 OTM puts and 1-month S&P 500 OTM calls are traded every other day on 1/12th of the portfolio. Each trade covers 1/12th of the portfolio’s notional value.
Overall, there are 12 tranches of 28-day collars in place at any given time – traded every other day – providing portfolio protection. This approach allows for the costless, dynamic adjustment of the portfolio hedge to the current market level. And it upholds the fund’s commitment to systematic hedging, the reduction of path dependency and the elimination of “market timing” risk.
Gamma: Shorter-term options are utilized in the hedge strategy because they have more Gamma imbedded in their price compared to longer-term options, so the puts utilized in the hedge will increase in value more quickly during a market downturn. This allows for the hedge to be monetized and provides the investor with the opportunity to invest in equities at lower prices. And as the market rises, the hedge can be “rolled up,” increasing the opportunity for more market upside.
Volatility Based Strike Selection: The strategy calls for the selection of optimal 28-day/20 delta put options. The 20-delta target allows for dynamic adjustment to changes in volatility and implies a 20- percent probability that the option will finish “in the money,” given perceived levels of volatility over the coming month. In a low volatility market, we expect lower FUTURE exposure as we roll into new trades – VIX 12 to 15 percent. In a high volatility market, we expect higher FUTURE exposure as we roll into new trades – VIX +15 percent.
There are multiple reasons for selecting the 20 Delta option:
1) Dynamic strike selection provides optimal balance of cost to protection – the closer to the money the option, the more expensive to purchase.
2) Allows for the selection of a call option further OTM, providing more room for capital appreciation in the fund’s equity positions.
3) Incorporates levels of volatility in strike selection, allowing for more upside exposure following market selloffs, as volatility spikes after the pullback.
By selecting options based on delta, rather than by percentage of OTM-ness, the option collar hedging strategy avoids purchasing protection when it is most expensive, while also increasing upside capture potential after the market has moved lower. A good analogy for this approach is to view the market participation afforded as an accordion which compresses when volatility is low and expands after volatility spikes. (Slide 13 Insert)
Conclusion
Most investors have a need for equity exposure to some degree, yet they fear the destruction that a market correction, or left tail, will inevitably have on their portfolio. Eaton Vance created a solution to address those fears and allow investors to maintain equity exposure within their portfolio over the long term, all the while providing protection against severe market selloffs; the Hedged Stock fund, utilizing a systematic, rules-based staggered collar option strategy.
The “costless” approach has successfully addressed the issues and drawbacks inherent in other widely utilized hedge strategies, such as exorbitant expense, fixed-strike and path dependency, and the failure to solve for market volatility.
Then there is the issue of a bull market that has grown long in the tooth, giving some pause to even the most ardent investors. The current bull cycle sees the market poised not far from its record highs, having tripled from the 2009 lows. And the valuation seems rich, with the S&P 500 now trading at 20x earnings compared with the historical multiple of 15x. Not to mention the headwinds certain to appear when the Fed eventually continues with it program to raise rates. No matter the amount of upside or length of time remaining in this bull cycle, exercising caution and utilizing some sort of a hedged equity strategy would appear prudent for any investor.
Bottom line, the Eaton Vance Hedge Stock Fund and hedge strategy has afforded shareholders with piece of mind and strong risk-adjusted returns that far outstrip those offered by investment in the S&P 500.