Using Index Options to Improve the Performance of Dynamic Asset Allocation Strategies

Noël Amenc, Philippe Malaise, Lionel Martellini, Daphné Sfeir: It has been long argued that equity managers can use derivatives markets to help implement a systematic risk management process designed to enhance the performance of their portfolio (see for example Ineichen (2002) for a recent reference).

Auteur(s) :

Noel Amenc

Professor of Finance, EDHEC Graduate School of Business

Philippe Malaise

Professor of Finance, EDHEC Graduate School of Business

Lionel Martellini

Professor of Finance, EDHEC Graduate School of Business

Daphne Sfeir

Senior Research Engineer, EDHEC Risk and Asset Management Research Centre

These derivatives instruments can be used in the context of completeness portfolios that are designed not to interfere with the original portfolio composition, so that they can be used to generate what has been labelled portable beta benefits (Amenc et al. (2004)). Consider for example the case of long/short equity hedge fund managers. Since the vast majority of these managers favor stock picking as a way to generate abnormal return in a pure bottom-up process, they do not generally actively manage their market exposure, and most of them end up having a net long bias. This can be seen for example from the correlation of HFR Equity Hedge (a prominent index for long/short hedge fund managers) with the S&P500, which turns out to be equal to 0.63 based on monthly data over the period 1990-2000. This is due to the fact that these managers, most of them being originally long-only mutual fund managers, typically feel more comfortable at detecting undervalued stocks than overvalued stocks. This long bias, which is not the result of an active bet on a bullish market trend but merely the result of a lack of perceived opportunities on the short selling side, has undoubtedly explained a large fraction of the performance of these managers in the extended bull market periods of the 90s. On the other hand, it has very significantly hurt their performance in the past few years of market downturns. Similarly, long/short managers, even those who target market neutrality, have unintended time-varying residual exposure to a variety of sectors or investment styles (growth or value, small cap or large cap) resulting from their bottom-up stock picking decisions. Futures contracts can be used to correct for such intended biases, and ensure that the portfolio factor exposure is consistent with the manager’s active views. In case the manager is a pure stock picker who has no views on systematic factors, it is recommended that he/she uses derivatives products to systematically neutralise the exposure of the portfolio with respect to the pervasive risk factors. In the absence of a systematic risk management process, and since a bottom-up selection process is not likely to lead to a market and factor neutral portfolio, it is not obvious to extract from the portfolio performance anything but a very noisy signal on the managers’ pure stock picking ability. There actually exists a second possible form of an active asset allocation strategy involving implementing an option-based portfolio strategy, of which the sole objective is to modify the asset allocation risk profile in the portfolio. In particular, it is well-known that options on equity indices can be used to truncate return distributions with an aim at eliminating the few worst (and best) outliers generated from managers’ forecast errors. In this paper, we consider the use of options in equity portfolios from a different angle in that we show how suitably designed option strategies can also be used to enhance the performance of a market timing strategy, the objective being to design a program which would consistently add value during the periods of calm markets, which are typically not favourable to timing strategies. The remaining part of this paper is organised as follows. In a first section, we present the case for tactical asset allocation (TAA) decisions. In a second section, we argue that tactical asset allocators would strongly benefit from using options on equity indices to implement truncated return strategies that aim at enhancing the performance and/or at reducing the risk of a TAA program. In a third section, we conduct a numerical experiment leading to the implementation of the option overlay strategy.

Type : Working paper
Date : le 06/10/2004
Pôle de recherche Finance

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