PUTW to diversify sequence of returns

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CountOnIt
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PUTW to diversify sequence of returns

Post by CountOnIt » Thu Jun 14, 2018 1:49 pm

Hello Bogleheads,

I'm seeking advice on using PUTW to diversify sequence of return risk on equities. I am thinking of substituting this for a modest portion of my domestic equities in a 3 fund investing approach (Domestic equities, global equities, and debt).

It makes intuitive sense to me that PUTW should offer similar returns over long periods of time - When you write an at-the-money put, you have the same downside as purchasing the underlying security. In an efficient market, you should receive an equivalent return for assuming similar risk. I understand the return profile for writing puts is significantly different than from simply owning the underlying security - that is why I believe PUTW would offer diversity with respect to the sequence-of-returns (for equities) but it should offer similar returns in the long run. Having diversity in the sequence-of-returns should flatten out some of the volatility in my portfolio without sacrificing long term gains (besides the 0.38% expense ratio).

Thank you for your help!

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k66
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Re: PUTW to diversify sequence of returns

Post by k66 » Thu Jun 14, 2018 5:47 pm

CountOnIt wrote:
Thu Jun 14, 2018 1:49 pm
Hello Bogleheads,

I'm seeking advice on using PUTW to diversify sequence of return risk on equities. I am thinking of substituting this for a modest portion of my domestic equities in a 3 fund investing approach (Domestic equities, global equities, and debt).

It makes intuitive sense to me that PUTW should offer similar returns over long periods of time - When you write an at-the-money put, you have the same downside as purchasing the underlying security. In an efficient market, you should receive an equivalent return for assuming similar risk. I understand the return profile for writing puts is significantly different than from simply owning the underlying security - that is why I believe PUTW would offer diversity with respect to the sequence-of-returns (for equities) but it should offer similar returns in the long run. Having diversity in the sequence-of-returns should flatten out some of the volatility in my portfolio without sacrificing long term gains (besides the 0.38% expense ratio).

Thank you for your help!
PUTW (or the WisdomTree CBOE S&P500 PutWriteStrat ETF) appears to walk in general lock-step with typical S&P 500 ETFs (e.g. VOO) or even broad-market ETFs (e.g. VTI).

I guess I don't see any potential sequence resiliency in the actual results (Feb 26, 2016 to June 14, 2018 as presented by Morningstar, which gives +17.65% for PUTW, +46.34% for VTI, and +43.93% for VOO over that period).
LOSER of the Boglehead Contest 2015 | lang may yer lum reek

stlutz
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Re: PUTW to diversify sequence of returns

Post by stlutz » Thu Jun 14, 2018 6:25 pm

Because it has the income from writing the put options, PUTW will do better in a down market that the S&P 500 and will give up return in an up market. Its backtested index went down signficantly less than the 500 during the 2008 crash.

I would put this fund in the same general bucket a low volatility stock ETF like USMV. I think both are valid options in the retiree toolbox.

That said, what would be your stock/bond allocation if you didn't use PUTW? If you have a high stock allocation, then the most efficient way to reduce your risk is to add more bonds. I think funds like PUTW or USMV make the most sense if you have a high bond holding (e.g. 50%+) but you want to de-risk the stock portion of your portfolio further.

CountOnIt
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Re: PUTW to diversify sequence of returns

Post by CountOnIt » Thu Jun 14, 2018 10:14 pm

stlutz wrote:
Thu Jun 14, 2018 6:25 pm
That said, what would be your stock/bond allocation if you didn't use PUTW?
I am in my 30’s and have a relatively aggressive risk-tolerance. That said, I would certainly be interested in an investment that has an expected return that matches the market in the long-run but provides some diversification to the sequence-of-returns/reduced beta. I was looking at PUTW as a substitute for domestic equities.
k66 wrote:
Thu Jun 14, 2018 5:47 pm
I guess I don't see any potential sequence resiliency in the actual results (Feb 26, 2016 to June 14, 2018 as presented by Morningstar, which gives +17.65% for PUTW, +46.34% for VTI, and +43.93% for VOO over that period).
In my initial search for information on PUTW, I found this thread where an author supports that the Put-Write strategy is quite competitive with the S&P in the long-run (viewtopic.php?t=224164&start=50). The CBOE shows a convincing chart that a put-write strategy can provide returns comparable with the S&P (https://www.cboe.com/micro/put/putwrite-fact-sheet.pdf). I understand two investments can have the same expected returns and have very different realized returns. I'm not that surprised that the realized returns are different over the two-year time period you cite - especially given the strong bull run. I think the horizon for the realized returns to converge could be over several market cycles (being in my 30's, I am ok with a 20-30 year horizon).

I do not have confusion on how options contractually work. I get a little foggy in the theory of pricing them. I understand the premiums should compensate for expected volatility – but I have not vested myself in calculating those premiums myself. I believe the underlying question I have is: Are the expected returns of covered put-writing (PUTW) equivalent to the expected returns of holding the underlying security in the long-run?

My intuition is yes. Is “insurance” for the S&P (an at-the-money-put option) priced efficiently, or does it favor the seller or the buyer of the insurance? If the person selling insurance is effectively taking all of the down-side risk, shouldn’t their expected return be equivalent to another investor holding S&P without any “insurance” (and has the same down-side risk exposure that the put-writer has)?

If they do have the same expected returns, then I would rather be both an insurance-writer and a holder of the S&P (rather than one or the other) - both investments provide the same expected returns, but because their day-to-day returns are different, my returns should be slightly smoothed. I can hold the investment in a Roth IRA, so I am not concerned about the different tax-treatments of these strategies.

While I feel strong about my intuition that the two should have theoretically equivalent expected returns in the long-run, I am asking for someone better at option pricing theory to confirm or deny this (I understand the "long run" here may take one or more business cycles to play out. I have a 20-30 year "long-run" horizon). Then, as an investment strategy, I am seeking advice on if this seems reasonable to implement or not. Is it worth paying the 0.38% expense ratio to have this added diversification?

stlutz
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Re: PUTW to diversify sequence of returns

Post by stlutz » Thu Jun 14, 2018 10:31 pm

Is it worth paying the 0.38% expense ratio to have this added diversification?
It is worth keeping in mind that the backtests do not include any expenses, and this fund tends to trail the benchmark by a little more than it's expense ratio. So, you lose about .5% per year.

I'd also keep in mind that the directionality of your returns with PUTW would be the same as with the overall stock market. PUTW is not going to be up 10% when the market is down 20%. It might only be be down, say, 12% in that case which is certainly nice, but possibly not overly exciting.
While I feel strong about my intuition that the two should have theoretically equivalent expected returns in the long-run, I am asking for someone better at option pricing theory to confirm or deny this
The conventional wisdom is that put options are generally overpriced for the buyer. And there is still more talk in the broader investment community about buying puts for "protection" than in selling puts for return. So, I think that bodes well for the strategy.

On the other hand, the backtest results are well publicized which suggests that at some point, the free lunch will be eliminated. But there are a lot of other strategies where free lunches are being more aggressively eliminated at the moment, so my guess would be that the put-write strategy has some life in it.

I actually have thought about PUTW. I have opted not to invest mostly because of expenses, because I think a low vol fund better serves the desired goal, and because I don't have any way to ascertain when the strategy should no longer work. On the final point, perhaps someone who is more of an expert in option pricing than I am can determine that. I'm not that person and it's unlikely I will become that person in the future.

david1082b
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Re: PUTW to diversify sequence of returns

Post by david1082b » Thu Jun 14, 2018 11:10 pm

CountOnIt wrote:
Thu Jun 14, 2018 10:14 pm

In my initial search for information on PUTW, I found this thread where an author supports that the Put-Write strategy is quite competitive with the S&P in the long-run (viewtopic.php?t=224164&start=50). The CBOE shows a convincing chart that a put-write strategy can provide returns comparable with the S&P (https://www.cboe.com/micro/put/putwrite-fact-sheet.pdf).
Using present tense to describe past investment results has often been frowned upon here. You could say it was competitive. Saying it "is competitive" implies it has some innate ability to be competitive that will never change. Of course, the CBOE's chart could be misleading. What if it failed to include trading fees? Maybe the strategy never was that competitive? CBOE's conflict of interest needs to be accounted for. An options exchange promoting an options strategy as competitive to a major stock index seems potentially problematic to me.

Even if it was competitive in the past after fees, what if so many people try the idea that it fades away in performance due to being too popular? When anyone can buy an ETF to do the strategy, will that increase the supply of puts a lot so their prices go down and thus reduce the performance?

CountOnIt
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Re: PUTW to diversify sequence of returns

Post by CountOnIt » Thu Jun 14, 2018 11:15 pm

Thanks for the feedback.
stlutz wrote:
Thu Jun 14, 2018 10:31 pm
It is worth keeping in mind that the backtests do not include any expenses, and this fund tends to trail the benchmark by a little more than it's expense ratio. So, you lose about .5% per year.
So I guess the takeaway is that if I have such a long horizon, I should take my low-cost index funds and be happy.

Since it doesn't seem to exactly be a no-brainer, I wouldn't have the confidence to take a position sizable enough to really have a material impact my portfolio. Therefore I might as well keep it simple (KISS) for now.
stlutz wrote:
Thu Jun 14, 2018 10:31 pm
On the final point, perhaps someone who is more of an expert in option pricing than I am can determine that.
I am still curious to hear the thoughts of an options expert on this.

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whodidntante
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Re: PUTW to diversify sequence of returns

Post by whodidntante » Thu Jun 14, 2018 11:38 pm

This fund keeps a lot of cash around to avoid ruin of the fund. You could have risk control without the cash drag. It is probably more efficient to write naked puts yourself backed by margin, assuming you have plenty of liquidity. I don't think your broker will even allow that without plenty of liquidity.

stlutz
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Re: PUTW to diversify sequence of returns

Post by stlutz » Fri Jun 15, 2018 12:38 am

It is probably more efficient to write naked puts yourself backed by margin, assuming you have plenty of liquidity. I don't think your broker will even allow that without plenty of liquidity.
If you're going to do it yourself, you almost have to do it this way. The CBOE backtest assumes you invest the cash in T-bills with no expenses deducted. Brokers of course pay you a much lower cash rate than the T-bill rate on cash collateral. So, if you're going to do it yourself w/o margin, you have this drag plus the option commissions. For most people, I think PUTW ends up being cheaper than DIY, again assuming no margin.

CountOnIt
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Re: PUTW to diversify sequence of returns

Post by CountOnIt » Fri Jun 15, 2018 9:56 am

david1082b wrote:
Thu Jun 14, 2018 11:10 pm
Saying it "is competitive" implies it has some innate ability to be competitive that will never change.
Fair point that I need to be careful about how I talk about past returns. To be fair, I AM positing/asking for confirmation/dispute that the theoretical expected returns should be equivalent in the long run. To that extent, we are talking about the returns being tied together at a theoretical level. I think that would qualify as an "innate ability to be competitive."
whodidntante wrote:
Thu Jun 14, 2018 11:38 pm
You could have risk control without the cash drag. It is probably more efficient to write naked puts yourself backed by margin, assuming you have plenty of liquidity.
To be fair, we should then benchmark these returns against some sort of levered S&P index rather than a simple buy and hold. I think if you were looking to hold a levered position, then this could be more efficient - you don't have to pay interest on a put that's backed by margin (but where you never actually borrow the cash). If you wanted a similar exposure by simply holding the security, you would have to lever up and pay interest.
stlutz wrote:
Fri Jun 15, 2018 12:38 am
For most people, I think PUTW ends up being cheaper than DIY, again assuming no margin.
The transaction costs of executing this myself (and the operational risk of messing it up) mean I am unlikely to do this manually on my own.

Also, I believe most (all?) brokerages will not give you margin in a tax advantaged account - so then you need to consider the tax consequences of trading in options rather than buy-and-hold, which is not trivial.

lack_ey
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Re: PUTW to diversify sequence of returns

Post by lack_ey » Fri Jun 15, 2018 10:13 am

The expected returns should not be equivalent over time, I would think, even before costs. Downside beta is not 1 (and upside is definitely way less than 1). Part of the equity risk premium seems to come from the uncertainty of how much the upside could be, not just uncertainty on the downside. Overall volatility and drawdowns are lower than pure equity exposure.

That said, before costs it probably is more efficient than pure equities because it's effectively gaining exposure to returns from both the equity risk premium (long stocks) and volatility risk premium (short volatility), which is diversifying.

I know, the historical returns on the S&P 500 computed for the index looks better than the S&P 500 in the backtest shown [edit: totally messed up some words originally]. I don't think that's going to be sustained.


If you've wondered why the PutWrite index (sell puts backed by cash) seems to have done better than BuyWrite (own stocks and sell calls against them), this is quick and informative:
https://www.aqr.com/~/media/files/persp ... ritevf.pdf
Short story: a difference in market exposure on option expiry dates.
Last edited by lack_ey on Fri Jun 15, 2018 11:56 am, edited 1 time in total.

CountOnIt
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Re: PUTW to diversify sequence of returns

Post by CountOnIt » Fri Jun 15, 2018 11:45 am

Thank you for your comments. I obviously want to understand any investment before I enter into it. This is my first discussion on Bogleheads - it is a pleasant experience to be able to air out an idea and to receive thoughtful feedback on it.
lack_ey wrote:
Fri Jun 15, 2018 10:13 am
That said, before costs it probably is more efficient than pure equities because it's effectively gaining exposure to returns from both the equity risk premium (long stocks) and volatility risk premium (short volatility), which is diversifying.
I think this is the most succinct way to put into words how I was thinking about the potential benefits of adding exposure to PUTW. In a 3-fund portfolio, I don't have access to the volatility risk premium. I see benefits to adding exposure to volatility risk premium across long investment horizons if that can be done in an efficient way. I just came across this seekingalpha article that may be an appropriate read for anyone else interested in gaining exposure to volatility risk premium. https://seekingalpha.com/article/381533 ... sk-premium

I guess that leaves the question - does PUTW provide that exposure in an efficient enough way or is there a more efficient way to gain this exposure?
lack_ey wrote:
Fri Jun 15, 2018 10:13 am
If you've wondered why the PutWrite index (sell puts backed by cash) seems to have done better than BuyWrite (own stocks and sell calls against them), this is quick and informative:
https://www.aqr.com/~/media/files/persp ... ritevf.pdf
Short story: a difference in market exposure on option expiry dates.
I found this read interesting - essentially even the ETF has trouble maintaining the PutWrite (and BuyWrite) positions 100% of the time. For those considering taking this position through trading by yourself, maybe you can succeed where the ETF falls short, but I don't believe I would be able to consistently beat the pros at maintaining the desired exposure.

stlutz
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Re: PUTW to diversify sequence of returns

Post by stlutz » Fri Jun 15, 2018 11:46 am

If you've wondered why the PutWrite index (sell puts backed by cash) seems to have done better than BuyWrite (own stocks and sell calls against them), this is quick and informative:
https://www.aqr.com/~/media/files/persp ... ritevf.pdf
Short story: a difference in market exposure on option expiry dates.
CBOE actually looked into this as well and largely came to the same conclusion:

http://www.cboe.com/framed/pdfframed.as ... +Conundrum

ThrustVectoring
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Re: PUTW to diversify sequence of returns

Post by ThrustVectoring » Fri Jun 15, 2018 11:48 am

Another explanation for the relative attractiveness of put-write is in terms of Bet-Against-Beta factor. Structurally, the trade has lower risk and lower return, so you'd need some kind of leverage in order to get the same absolute return. Since the market has a lot of money under leverage constraints, you can expect strategies with more embedded leverage to be over-priced by the market.

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