My take on the current market environment and portfolio creation – Normally a portfolio starts with its’ foundation, equities. Equities have produced exceptionally high and robust returns over extended periods and are generally expected to continue to offer an attractive risk premium to those who are willing to accept the risks they carry. But we all know it is not prudent to put all your eggs in one basket, so people tend to diversify their core equity holdings with bonds. Bonds tend to be negatively correlated with equities in typical market environments and are generally expected to hold their par value in times of stress, providing a floor to the total assets at risk in a portfolio. There is a cost to pay for this protection and that cost fluctuates in time. Over the last 50 years, a constant maturity 30-year Treasury bond holding has returned an average of about 8% annually, while the S&P 500 (with dividends reinvested) averaged about 11%. Over the past half century, bonds were an attractive way to protect the portfolio given their relatively modest 3% opportunity cost, relative to equities. This can be a bit misleading because it is including the 1980’s where the 30 Year Treasury returns were as high as 15.08% September 21^st, 1981 to their low point in the decade of 7.18% on 06/30/1986. A majority of the 80’s the 30-year treasury fluctuated between 7.5% and 15%. As you can see in the chart below though 30 Year Treasury Rates have been on a steady and consistent decline.

30 Year Treasury Rate – 39 Year Historical Chart

Interactive chart showing the daily 30 year treasury yield back to 1977. The U.S Treasury suspended issuance of the 30 year bond between 2/15/2002 and 2/9/2006. The current 30 year treasury yield as of April 02, 2021 is 2.35%

Source: https://www.macrotrends.net/2521/30-year-treasury-bond-rate-yield-chart

When yields are very low, as they are today, the expected cost of holding Treasuries relative to equities can rise substantially above the 3% opportunity cost, which brings into question whether they still fit the bill as the go-to-choice for diversifying equity-dominated portfolios. Risk Management at the portfolio level can be difficult but it is magnified when the risk-free rate (30-year treasury) is a percentage point or two away from zero. Is there a way that we can lessen a portfolio’s equity risk without lessening its equity exposure, yet still participate in an equity market that has provided robust returns over a long period of time?

The gap between the S&P 500 and the 30 Year Treasury at the end of 2020 was 18.4% compared to 2.33% (30 Year Treasury Yield on 1/02/20). That represents a large spread of potential missed opportunity on equity returns to add bond diversification to your portfolio. The interest rate on fixed income instruments has created an opportunity for a good financial advisor to get a bit creative with his/her portfolio creation approach. If we introduce derivatives (Equity Option Contracts) into the portfolio creation process, we can limit equity downside exposure while still participating in the upside that we have come to appreciate with equities over time. To be specific, put options on the equity market have the potential to pay the holder handsomely when markets experience a downturn, offering a distinct way of protecting an equity-focused portfolio against severe losses beyond the traditional method of diversifying into other asset classes like bonds. 

Depending on the client, their risk tolerance and level of sophistication, I may recommend using our “put overlay” component in the portfolio and keeping more of the portfolio in equities. The put overlay component consists of a series of deep out of the money put options at different expirations, which are rolled systematically, and potentially also monetized before their expected expiration date. This strategy can reduce the BETA of a portfolio while keeping a bulk (70% +) of the portfolio in equities. This strategy can introduce convexity to your portfolio, which can lead to portfolio performance that is positive during times of extreme stress, due to the incredible leverage that can be embedded in options.

One of the areas that can make a strategy like this unattractive is the overall cost of “insurance” or the cost of the put option contracts. Normally, options contract pricing will fluctuate with the VIX (Chicago Board Options Exchange’s CBOE volatility index) which is a popular measure of the stock market’s expectation of volatility, based on the S&P 500 index options. The VIX is currently (4-6-21) under 20, which offers an attractive entry point because volatility is currently considered “low” and options costs tend to be lower when volatility is low.

This strategy can perform particularly well when there are large market corrections, like we saw in 2008 and 2020, due to the nature of either the ability to exit your put strategy with a significant profit, or keep the strategy on and keep the portfolio from large draw downs and then let the compound interest continue from a higher portfolio balance.

If you have over $1,500,000 in investible assets and want to further discuss a strategy like this, I would be more than happy to design a client specific portfolio with a put overlay component. The reason for the asset minimum with a strategy like this is because of the labor/research intensive nature of the strategy.

* This article is intended for a broad audience and should not constitute as financial advice. Please consult with a financial professional for your own personal situation.

Securities offered through Parkland Securities, LLC, member FINRA/SIPC.