Did Volatility Risk Premium Strategies Deliver in March?

APR Perspectives 2020

The longest bull market in history ended abruptly in March as U.S. stocks finished their worst quarter since the Global Financial Crisis (GFC). The magnitude and speed by which the S&P 500 index sold off from late February through March shocked investors; what happened over multiple years during the GFC happened in a matter of weeks. During that same time period, the CBOE Volatility Index (VIX) hit an all-time high, as Joe McGuane, CFA markets tried to discern the extent of the economic fallout Senior Research Analyst, Alternatives from the spread of COVID-19. Volatility Risk Premium (VRP) strategies — which are designed to provide equity upside but downside protection — were not immune to the financial market dislocations but performed in line with our expectations and are set to rebound more quickly when broader market indices stabilize.

BACKGROUND Jessica Noviskis, CFA As a quick refresher, VRP strategy returns are not driven by underlying security Senior Research Analyst, fundamentals such as earnings, dividends, interest rates, or spreads. Instead, these Hedge Funds strategies systematically sell put and call options on the S&P 500, essentially selling insurance to investors who wish to hedge their long equity exposure. They collect the premiums investors are willing to pay to avoid equity market volatility. The funds are designed to profit from the inherent spread between implied and realized market volatility, without having to make a tactical call on the future direction or volatility of equity markets. Leverage is not used in VRP strategies and all options sold are fully collateralized with cash. The options contracts are listed on the Chicago Board of Options Exchange (CBOE) and backed by the Option Clearing Corp (OCC); there is no use of over-the-counter contracts. The VIX measures the 30-day implied volatility of the S&P 500 index by way of the options market and has served as a “fear gauge” for the market broadly since the

CHICAGO BALTIMORE MILWAUKEE PHILADELPHIA ST. LOUIS early 1990s. When the market peaked on February 19th this year, the VIX sat at 14. During the last week of February, the VIX index delivered its second largest weekly increase on record, surging from 17 to nearly 50, before settling in at 40 on Friday, February 28th. For recent comparison, the “Volpocalypse” (Feb. 2018) and Christmas Eve crash (Dec. 2018) registered peak closing VIX levels of 37 and 36, respectively. On Monday, March 16th, the VIX surged 25 points to an all-time high of 82.69, the largest financial insurance repricing in history, as markets digested the Fed’s emergency 100bps interest rate cut and the potential economic fallout from COVID-19. The VIX held steady in the 60s during the week of March 23rd, despite the passage of $2 trillion in fiscal stimulus and $4 trillion of Central Bank support.

CBOE LIQUIDITY The CBOE made the decision on Monday, March 16th to temporarily close its options trading floor as a precautionary measure to prevent the potential spread of the virus. Exhibit 1 below shows the average daily volumes of SPX options over the past 20 years, highlighting the unprecedented nature of 2020’s first quarter. With market makers working from home, VRP mangers reported wider bid/ask spreads and less volume at those levels. Despite those wider spreads, managers were able to execute their trades relatively close to mid-market levels and trade at desired prices. As the VIX spiked over the past month, options liquidity remained available on the CBOE allowing managers to trade without any issues.

Exhibit 1: Average Daily Volumes of SPX Options 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: CBOE Q1 2020

PREMIUM COLLECTION Exhibit 2 on the following page shows how option premiums changed over the course of the first quarter for three of Marquette’s recommended VRP strategies. All three managers reported a sudden increase in option premiums as the VIX started moving toward the end of February. Manager A employs a systematic short strangle strategy, selling out-of-the-money put and call options on the S&P 500. The cash collateral is invested 50% in U.S. Treasures and 50% in the S&P 500 index. Options are rolled on a weekly basis to improve diversification across strikes, expiration dates, and volatility levels. Premiums spiked with the VIX in the final week of February, with OTM put premiums going to 1% and OTM call premiums to 0.50%. The week of March 16th, OTM put premiums hit 3.70% and OTM call premiums reached 1.50%, the largest seen over the life of the strategy.

2 Exhibit 2: Q1 Option Premium Collection 10% 100

8% 80

6% 60

4% 40 VIX

2% 20 Option Premium 0% 0 Jan-20 Jan-20 Jan-20 Feb-20 Feb-20 Mar-20 Mar-20 VIX OTM Put Premium (Mgr A) OTM Call Premium (Mgr A) Put Premium 30-day Tenor (Mgr B) Put Premium 2-week Tenor (Mgr C) Sources: CBOE and underlying managers

Manager B employs a systematic at-the-money put selling strategy, with cash collateral invested 100% in short duration U.S. Treasuries. As the chart shows, by the end of February, 30-day at-the-money premiums had reached 4%, meaning the breakeven for those options would be a 4% loss in the S&P 500 over the next 30 days. That premium got as high as 8% during the week of March 16th as the VIX hit its peak. Manager C employs a systematic at-the-money put selling strategy, with cash collateral invested 100% in short duration U.S. Treasuries. Premiums on the 2-week tenor puts spiked to 7% during the week of March 16th, the largest the manager has seen since the inception of the strategy.

PERFORMANCE The below table shows performance of three VRP managers that Marquette tracks closely. In the first quarter, all three managers outperformed the CBOE Putwrite and CBOE COMBO indies, as well as the S&P 500. As we have noted in previous market sell-offs, these strategies can initially see higher than average downside capture, as risk is repriced at higher implied volatility levels. However, as shown earlier in this article, option premiums have also repriced higher, which should help VRP strategies rebound more quickly coming out of this downturn. VRP strategies are essentially selling insurance, which is in very high demand right now. Given the current environment, the opportunity set appears robust for VRP strategies, with widening strikes and the highest premiums collected over the life of the funds.

Exhibit 3: VRP Manager Performance (%)

2011* 2012 2013 2014 2015 2016 2017 2018 2019 YTD** Manager A 6.2 9.1 16.0 8.4 3.9 8.2 11.9 -2.9 16.3 -16.1 Manager B -- 13.8 12.3 7.8 6.9 8.5 10.9 -5.6 16.2 -14.1 Manager C ------12.7 14.2 -9.8 18.6 -17.7 CBOE PutWrite 6.2 8.1 12.3 6.4 6.4 7.8 10.8 -5.9 13.5 -20.7 CBOE COMBO 11.3 7.5 16.5 5.5 4.3 7.9 15.3 -4.9 17.7 -21.8 HFRI Equity Hedge -4.3 7.4 14.3 1.8 -1.0 5.5 13.5 -7.1 13.7 -13.0 S&P 500 4.0% 16.0 32.4 13.7 1.4 12.0 21.8 -4.4 31.5 -19.6

*September–December 2011. **YTD manager performances are estimates; performance through March 31, 2020 Sources: Bloomberg, HFR, and CBOE

3 CONCLUSION VRP strategies were not immune from the unprecedented downward move across global markets in the first quarter. While the drawdown was notable, it was entirely within the bounds of expectations for these strategies. Given the underlying equity exposures of writing options, during a market sell-off VRP strategy returns can initially appear worse than otherwise expected given the combination of losses in the underlying index and significant increases in option implied volatility levels. But as the option market adjusts to price in this additional volatility, premiums rise, generating additional return for VRP strategies. The defensive nature of VRP strategies tends to improve following this repricing of risk, as the higher volatility levels are monetized in the funds. Marquette will continue to track these VRP strategies closely in this elevated volatility environment and communicate performance that falls outside of expectations.

PREPARED BY MARQUETTE ASSOCIATES

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The sources of information used in this report are believed to be reliable. Marquette Associates, Inc. has not independently verified all of the information and its accuracy cannot be guaranteed. Opinions, estimates, projections and comments on financial market trends constitute our judgment and are subject to change without notice. References to specific securities are for illustrative purposes only and do not constitute recommendations. Past performance does not guarantee future results.

Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Marquette including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.

About Marquette Associates Marquette Associates is an independent investment consulting firm that guides institutional investment programs with a focused client service approach and careful research. Marquette has served a single mission since 1986 – enable institutions to become more effective investment stewards. Marquette is a completely independent and 100% employee-owned consultancy founded with the sole purpose of advising institutions. For more information, please visit www.marquetteassociates.com.