Wilshire Associates

Improving Diversification by Harvesting Volatility Risk Premiums The Cboe Russell 2000 Option Benchmark Suite MARCH 2020

Jeff Foley, Managing Director & Head of Business Operations, Wilshire Analytics

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As of 1/31/2020 5 Jersey City 10 Suzhou ©2020 Wilshire Associates. For Financial Professionals Only. 5 THE CBOE RUSSELL 2000 OPTION BENCHMARK SUITE Study: 19 Year Performance Analysis of Cboe Russell 2000 Option-Selling Index Strategies

Purpose of the Analysis • Wilshire Analytics conducted a historical performance analysis of four Cboe Russell 2000 Option-Selling Indexes to gauge how effectively they delivered as is generally expected from option-selling strategies, namely: improving diversification, managing tail risk and consistently compensating investors for providing downside cushion in the event of unexpected market volatility, referred to as the implied volatility risk premium (IVRP) • As designed, option-selling strategies are largely expected to outperform in bear markets and underperform in certain bull markets.

Study Criteria • 19 years of performance data (January 31, 2001 to December 31, 2019) for four Cboe Russell 2000 Option-Selling Indexes and relevant market benchmarks was analyzed, and wide range of risk measures calculated to provide a more complete picture of the behavior across time, various market regimes, and individual option-selling index strategies. Index included were: Cboe Russell 2000 Buywrite Index (BXR℠) Cboe Russell 2000 30-Delta Buywrite Index (BXRD℠) Cboe Russell 2000 Putwrite Index (PUTR℠) Cboe Russell 2000 Zero-Cost Spread Collar Index (CLLR℠)

TICKER INDEX POSITIONS HELD

Hold Russell 2000 stocks + Sell 1-mo. BXRSM Cboe Russell 2000 BuyWrite Index at-the-money Russell 2000 (RUT) call options

Cboe Russell 2000 Hold Russell 2000 stocks + Sell 1-mo. BXRDSM 30-Delta BuyWrite Index out-of-the-money 30-delta RUT call options

Hold U.S. Treasury Bills + Sell 1-mo. PUTRSM Cboe Russell 2000 PutWrite Index at-the-money RUT put options

Cboe Russell 2000 Hold Russell 2000 stocks + Buy RUT put CLLRSM Zero-Cost Put Spread Collar Index options spread + Sell RUT call options

Source: Wilshire Associates, Cboe

Expanded Efficient Frontier • 15% additional allocation of a Cboe PUTR Index to stock and bond portfolios improved returns by 8 basis points, and reduced standard deviation by 21 to 57 basis points (Exhibit 1).

Improved Tail Risk and Lower Volatility • All four Cboe indexes had lower volatility and maximum drawdowns than the Russell 2000 Index. The PUTR Index had a 29% lower standard deviation and 28% less severe drawdown than the Russell 2000 Index (Exhibit 2).

Richly Priced Options Premiums Harvested • All four Cboe indexes sold RUT options and collected monthly premiums. The BXR Index collected an average gross premium of 2.1%. RUT options were usually richly priced, as average implied exceeded average realized volatility by about 3.3 points (Exhibits 9 & 10).

Enhanced Risk-Adjusted Returns • The implied volatility risk premium fueled strong risk-adjusted returns for the PUTR Index, which demonstrated a 28% higher Sharpe Ratio than Russell 2000 Index (Exhibit 4).

• A 15% additional allocation of a Cboe PUTR index to a traditional stock/bond portfolio, funded directly/redirected from the allocation to stocks clearly demonstrates the diversification benefit. • We see a consistently improvement to the risk/reward profile: returns improve by 8 points at all points along the curve, and risk reduced from 21 to 57 basis points.

JANUARY 31, 2001–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe, Bloomberg

• A comparison of the return distributions for the PUTR versus the Russell 2000 Index demonstrates a decrease in volatility by narrowing the tails, in exchange for a reduced median and upside return range. • PUTR reduced return distributions by 29% at the 95% confidence level versus the Russell 2000. • Russell 2000 showed six months of returns above 10% and an average return of 12.70 vs. 5.45 percent for PUTR across the same six months; meanwhile, the benchmark showed nine months with returns -10% or lower, with an average return of -13.16 vs. -10.76 for PUTR across the same nine months.

JANUARY 31, 2001–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe

• All four Cboe Russell 2000 Option indexes demonstrated a lower risk as represented by standard deviation than the underlying index Russell 2000 Index during the time period studied • Cboe PUTR delivered the highest returns of the four at 7.5%, with an 28.7% reduction in risk versus the Russell 2000 Index and 14.4% less risk than the U.S. stock market; however, all Cboe Russell 2000 Indexes provided risk reductions ranging from 9.5% to 28.7% versus the underlying baseline • Regimes least advantageous for option-selling strategies on a returns basis alone are extreme bull markets (half the time window of this study), so results here are as expected based on strategy attributes

JANUARY 31, 2001–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe, Bloomberg

• Here we look to two risk-adjusted measures of return: Sharpe ratio and Sortino ratio • While both measure returns on a risk-adjusted basis, the Sortino ratio focuses on downside deviation only • Viewed together, these measures offer deeper insights into performance and the overall return profile • PUTR showed improved values across both measures vs. the underlying Russell 2000, with a 28% improved Sharpe ratio, and 20% improved Sortino ratio.

JANUARY 31, 2001–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe, Bloomberg

• During an unprecedented U.S. equity bull market, the PUTR Index sold richly priced RUT options and rose 297%, demonstrating more growth over time than did five of six of the other indexes studied, including benchmarks for both the broad U.S. equity, and broad U.S. bond market • Correlation to Russell 2000 ranged from 82% to 97% across the four Cboe Russell 2000 options-based indexes

JANUARY 31, 2001–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe, Bloomberg

• We compare all four option indexes versus each other, the underlying Russell 2000 Index and broad U.S. stock and bond market benchmarks, Russell 3000 and Bloomberg Barclays US Aggregate Bond Index, across an even wider range of analytical measures to provide an increasingly clear picture of performance • All four option indexes have better maximum drawdowns and lower standard deviations than the Russell 2000, with expected larger negative skewness. PUTR had the best results across the board of the option indexes studied, with better risk-adjusted returns and generating 1.87% Alpha versus the Russell 3000

JANUARY 31, 2001–DECEMBER 31, 2019

ANNUALIZED STANDARD BETA VS. ALPHA VS. MAXIMUM SHARPE SORTINO RATIO INDEX RETURN DEVIATION RUSSELL 3000 RUSSELL 3000 DRAWDOWN RATIO (MAR = 0.00%) SKEWNESS

PUTR 7.5% 13.4% 0.71 1.87% -38.1% 0.36 0.73 -1.94

BXR 5.5% 14.1% 0.80 -0.43% -45.4% 0.20 0.51 -1.56

CLLR 5.3% 14.9% 0.90 -1.04% -47.9% 0.18 0.49 -0.93

BXRD 6.8% 16.1% 0.96 0.28% -50.0% 0.26 0.58 -1.15

Russell 2000 Index 7.9% 18.8% 1.17 0.66% -52.9% 0.28 0.61 -0.54

Russell 3000 Index 7.0% 14.7% 1.00 0.00% -51.2% 0.29 0.68 -0.71

Bloomberg Barclays 4.6% 3.4% -0.03 2.10% -3.8% 0.58 2.50 -0.24 US Aggregate Bond Index

Source: Wilshire Associates, Cboe, Bloomberg

• All four index options perform as designed, which is to provide a cushion in challenging market regimes versus the broad market • PUTR showed lowest overall max drawdown at 38.1% and standard deviation of 13.4

JANUARY 31, 2001–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe, Bloomberg

• Select bull and bear market regime concentrations confirmed that all four options-selling indexes experienced less severe drawdowns and lower returns than the Russell 2000 • Cboe PUTR had a 36% less severe drawdown than the Russell 2000 Index during the first bear market regime, and the Cboe CLLR Index had a 23% less severe drawdown than the Russell 2000 during the second.

JANUARY 31, 2001–DECEMBER 31, 2019

*Return values are annualized. Source: Wilshire Associates, Cboe, Bloomberg

• Differences between the various option-selling strategies highlight differences in how harvesting of the premiums work with the likelihood of truncated potential • At-the-money (ATM) strategies, such as BXR and PUTR, focus on maximizing harvested premiums, combined with an off-setting basket of stocks or T-Bills, respectively • Premium size is a function of expected future volatility • Markets where expected volatility exceeds realized volatility create premium pricing that is above average, or rich, and can facilitate higher risk-adjusted returns for the options-selling strategy • Next, we’ll look at some examples where the richness of the premium is reduced by protracted volatility • Also, we’ll look at analysis demonstrating the symbiotic relationship between the premiums generated by systematically selling one-month at-the-money options on the RUT Index and values of the Cboe Russell 2000 Volatility Index (RVX)

• Here we see that the Cboe Russell 2000 Volatility Index (RVX) consistently understated subsequent realized volatility of the Russell 2000 Index, by a nominal 3.3 volatility points • The exception to this was during the steepest market downturn of the entire window of this study: the Financial Crisis, when realized volatility actually exceeded implied volatility multiple times • Since that time, we also see that both implied and realized volatility, as well as the spread between them, has trended downward, reducing the richness of the premiums – which are still consistent

JANUARY 31, 2004–DECEMBER 31, 2019

Source: Wilshire Associates, Cboe

• Note that, BXR and PUTR premiums, as well as the RVX are all functions of a market forecast for future volatility – in other words, they’re highly correlated with one another • Given that, here we take a closer look at gross premiums for the BXR • In spite of the time difference between the BXR rebalance strike time and RVX close, the correlation is 93.3% • The average premium for BXR across the 15+ years studied is 2.1%, an annualized contribution of 28.3%.

JANUARY 2004–DECEMBER 2019

Source: Wilshire Associates, Cboe

• 19 years of empirical data confirms that Cboe Russell 2000 Option Indexes delivered Russell 2000 type returns that expand the mean variance efficient frontier, help manage tail risk and capture the volatility risk premium on a consistent basis • Redirecting 15% of the equity allocation in a traditional stock/bond portfolio to PUTR clearly demonstrates a diversification benefit in terms of an improved risk/return profile • Risk measures such as standard deviation, return density and maximum drawdown confirmed that all Cboe Russell Option Indexes reduced risk • Strong risk-adjusted returns for all option-selling indexes were fueled by index options that were often richly priced, and market environments where expected volatility was higher than subsequent realized volatility • The average monthly call premium for BXR, highly correlated to PUTR, was 2.1% above its underlying value, and contributed 28.3% annualized return across the full 19 year window of performance studied

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All indexes in this paper (except the RVX Index) are total return indexes (pre-tax indexes that include reinvested dividends). Past performance is not predictive of future returns.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker or from The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606.

The information in this paper is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current.

Cboe® and VIX® are registered trademarks of, and BXR, BXMD, and PUTR and many other indexes are servicemarks of Cboe Options Exchange (Cboe). Russell, Russell 1000®, Russell 2000®, Russell 3000® and Russell MidCap® are registered trademarks of the Frank Russell Company, used under license. S&P® and S&P 500® are registered trademarks of Standard & Poor's Financial Services, LLC, and are licensed for use by Cboe. Cboe Exchange, Inc. provided funding for this study. This presentation is intended for financial professionals only. This presentation is not intended for the general public.

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