In a key development during the past week, Morningstar placed dozens of mutual funds in its new Option Writing category in its U.S Retail Category system.
LESS VOLATILITY FOR BENCHMARK INDEXES THAT WRITE SPX OPTIONS
Morningstar’s Category Index for the new Option Writing category is the CBOE S&P 500 BuyWrite Index (BXM). There are some people who still wonder if use of options usually adds to volatility, and if option writing strategies always have lower returns than equity indexes over the long term. However, please see the charts below for a comparison of six benchmark indexes, and note that since mid-1986 the CBOE S&P 500 30-Delta BuyWrite Index (BXMD) had the highest returns, and the BXM Index had the least volatility, when compared with the Citigroup Treasury Bond, S&P 500, MSCI EAFE, and S&P GSCI (commodity) indexes.
THREE STUDIES ON MUTUAL FUND USE OF OPTIONS
As investors digest new developments and analysis regarding Morningstar’s new Option Writing category, more analysis of mutual fund use of options is presented in three studies summarized below.
2015 STUDY BY KEITH BLACK AND ED SZADO
In 2015 Keith Black and Edward Szado published a paper “Performance Analysis of Options-Based Equity Mutual Funds, CEFs, and ETFs.” You can visit www.cboe.com/funds to click on different versions of the paper — Slide Presentation (30-page PDF), Highlights (4-page PDF), and Paper (28-page PDF). A version of the paper also recently was published in The Journal of Wealth Management.
The 2015 paper found that the number of ’40 Act funds (including 62 mutual funds, 9 ETFs and 48 closed-end funds (CEFs)) that used options grew from 10 in the year 2000 to 119 funds in 2014, and the paper provides a list of the names and ticker symbols for all 119 funds.
The study performed an analysis of the equal-weighted performance of 80 Options-Based Funds that focus on use of U.S. stock index options and/or equity options during the 15-year period from 2000 through 2014, and found that the Options-Based Funds had similar returns as the S&P 500 Index with lower volatility and lower maximum drawdowns.
Compared with the S&P 500 Index, the Options-Based Funds had higher risk-adjusted returns, as measured by the Sharpe Ratio, Sortino Ratio, and Stutzer Index.
2016 STUDY BY UNIVERSITY OF AUGSBURG
A 2016 paper by University of Augsburg professors on “The Benefits of Option Use by Mutual Funds” found that –
“… equity funds’ option use generates higher risk-adjusted performance. We further show that this is a direct effect of option use and not an indirect effect of other fund characteristics. Option use also directly results in lower systematic risk, as funds show significantly lower market betas during periods of options usage. Finally, mutual funds use options mainly for hedging as they primarily use protective puts and covered calls. These results are independent of known phenomena, such as the low beta anomaly, and robust to tests for endogeneity and a novel 5-factor model including an investable option strategy factor (IOS). Overall, our findings show that mutual fund option use is beneficial to investors and does not pose risk to the financial system as feared by the SEC. Our results are thus important for investors as well as regulators.”
2014 STUDY BY GOLDMAN SACHS
In 2014 at the CBOE Risk Management Conference, John Marshall of Goldman Sachs published a paper with a five-year study on “Mutual Fund Use of Options – Public Holdings and Trends.” Here are some key findings from the paper –
- STRATEGIES. The % of positions held by mutual funds in each options strategy – 64% in short calls, 22% in short puts, 8% in long puts, and 6% in long calls.
- MATURITIES. About 47% of short-options positions had a maturity of 30 days or less, while about 40% of long-options positions had a maturity of 30 days or less.
- TYPES OF OPTIONS. Over the past two years, fund usage of both single-stock options and index options has grown, while fund usage of ETF options has decreased.
- GROWTH IN ASSETS. Over the previous 5 years, assets under management for the option-using funds have grown 160%, versus 110% growth for their peer funds that do not use options.
- STRONGER PERFORMANCE. Over the 5-year period ending March 4, 2014, the funds that used options had higher returns, lower volatility, and higher risk-adjusted returns than their peer funds that do not use options.
BACKGROUND ON DEVELOPMENTS RE: FUND CATEGORIES IN PAST YEARS
Over the past decade I have spoken to numerous representatives of different mutual funds that used options, and many of these reps expressed concerns about the Morningstar categories – these reps told me that the Morningstar categories were very important, but the categories applied to their options-based fund (such as “Long-Short” or “Large Blend”) could be more accurately descriptive. Some of these representatives said that (1) they individually met with Morningstar to discuss the category applied to their fund, (2) they were interested in a the possibility of new Options category, and (3) they asked if CBOE could discuss the category topic with Morningstar. In 2014 I had a two-hour meeting with key Morningstar reps in which (1) I gave them an overview of performance of options-based benchmark indexes (such as the BXM Index) and some options-based mutual funds, (2) Morningstar reps told me that potential new Morningstar categories have several requirements, including the fact that there should be enough constituents to form the basis for reasonable peer group comparisons (e.g., a dozen funds generally would not be enough to generate a new category), and (3) I told Morningstar reps that in the future I would provide more information on many dozens of options-based funds. In early 2015 I was pleased to send to Morningstar the new study by Keith Black and Ed Szado that provided a list of 119 ’40 Act funds that used options (see more info on the study above).
BACKGROUND ON KEY MORNINGSTAR CATEGORIES
Morningstar states that their categories “help investors identify the top-performing funds, assess potential risk, and build well-diversified portfolios.” In the U.S., Morningstar supports 122 categories, which map into nine category groups (U.S. equity, sector equity, allocation, international equity, alternative, commodities, taxable bond, municipal bond, and money market). The category group indexes and category indexes listed with each category are used in Morningstar’s tools and reports to show performance relative to a benchmark.
Two of the key Alternative categories that could be of interest to people who invest in options or volatility products are:
Option Writing (introduced on April 29, 2016)
Option writing funds aim to generate a significant portion of their returns from the collection of premiums on options contracts sold. This category includes covered call strategies, put writing strategies, as well as options strategies that target returns primarily from contract premiums. In addition, option writing funds may seek to generate a portion of their returns, either indirectly or directly, from the volatility risk premium associated with options trading strategies.
- Category Group Index: S&P 500 TR USD
- Category Index: CBOE S&P 500 BuyWrite BXM
- Morningstar Index: Morningstar US Market TR USD
- Volatility (introduced on April 30, 2011)
- Volatility strategies trade volatility as an asset class. Directional volatility strategies aim to profit from the trend in the implied volatility embedded in derivatives referencing other asset classes. Volatility arbitrage seeks to profit from the implied volatility discrepancies between related securities.
- Category Group Index: S&P 500 VIX Short Term Futures TR USD
- Category Index: S&P 500 VIX Short Term Futures TR USD
- Morningstar Index: Morningstar Cash TR USD
I am looking forward to learning more about Morningstar’s new Option Writing category, and I will be interested to see if many funds in the new Option Writing category have less volatility than most funds in Morningstar’s domestic and global stock categories.