Defined benefit (DB) pensions schemes have recently been buying equity protection (put options) to reduce downside risk. But could writing puts ever make sense?
Downside risk management is important for any investor exposed to growth assets. Buying puts (options to sell assets at a certain level) can help, particularly if the cost of protection is attractively priced. But, playing devil’s advocate, could doing the exact opposite – writing puts – ever be a good idea?
At first this might read like an outlandish idea – why would an investor want to increase downside risk? Before dismissing it, it’s worth thinking why writing puts could actually boost expected returns and, perhaps counter-intuitively, improve diversification.
There’s empirical evidence that writing puts can generate positive returns. This is partly just because equities themselves earn a risk premium and more positive equity returns result in lower pay-outs to the holder of the put (all else equal). However additional returns can also arise – the so called “overpriced puts puzzle”. Indeed, backtesting indicates that writing puts can achieves a higher Sharpe ratio than the index itself. As an example, the chart below compares risk-adjusted returns on equity versus writing three-month 100% put options every quarter.
Importantly, writing puts can also diversify risk from the equity index over the long term, other than in the most extreme tail events. For example, writing three-month 100% put options every quarter, the only scenarios that are 100% correlated with the index are those where there’s a negative return every single quarter.
These become increasingly unlikely with time – akin to repeatedly tossing heads on a coin. After five years, for example, there’s less than a one in a million chance that every quarterly coin toss will have been a head. As such other than for the most extreme bad outcomes, returns from writing three-month 100% puts diversify returns on the underlying index.
The scatter plots below, based on simulations, illustrate how diversification helps more over longer time horizons. We’ve plotted annualised returns from writing puts against annualised returns on the underlying index.
(Note: we've omitted axes and titles so you can focus on the shapes)
As you can see, to start with the returns from writing puts and equity exposure are completely correlated on the downside. But the further you look out, the more 'regular' (or elliptical) the scatter plots become, with a correlation between returns of around 80%.
The upshot is that investors can achieve not only a positive return from writing puts, but also diversification from outright equity exposure. This may be particularly attractive to investors who are not, due to leverage and capital constraints, forced to invest in the highest-beta asset (equities) to reach their expected return target.
Short-term downside risk management obviously matters, and investors need to pay particular attention to shocks they wouldn’t be able to recover from. But for investors hoping to generate excess returns over the next few decades, we believe a diversifying source of return such as writing puts could deserve a place (alongside other diversifiers) in their growth strategy.
Note: many thanks go to Nic Barnes, Co-Chief Investment Officer at the RBS Group Pension Fund, for his collaboration on this topic.