Parametric Portfolio Associates is a sophisticated user of the U.S. options markets. The Seattle-based asset manager, which currently has $230 billion in assets under management, has been using derivatives for more than 30 years to deliver investment solutions to pension funds and other investors looking for alternative sources of return.
In this interview with MarketVoice, two Parametric executives talk about how they use equity index options for one strategy in particular. This strategy is based on extracting the "volatility risk premium" from the options market by systematically selling puts and calls. The key to the strategy is the historical tendency for options buyers to pay a premium to options sellers in return for protection from volatility. To put it another way, the level of volatility implied by the pricing of options is typically higher than the actual level of volatility. Options sellers profit from the difference, so long as they manage the risks effectively.
The first quarter of 2018 was a tough time for this type of strategy. In late January, equity market volatility exploded and a number of funds focused on options-selling strategies suffered big losses. For Parametric, however, the spike in volatility has served to demonstrate the strength of its offering, which is carefully designed to provide downside protection as well as upside returns. Its volatlity risk premium strategies had solid returns in the second quarter and assets under management rose to $18 billion.
We like index options because, a) they’re generally very liquid; b) they provide transparency; and c) they don’t introduce that idiosyncratic counterparty credit risk that we’re concerned about. And we can get good execution in that market.
- Tom Lee, Managing Director, Parametric
Tom Lee, Parametric's managing director for investment strategy and research, oversees the construction of the portfolio, and Larry Berman, the firm's managing director for trading and operations, is responsible for executing the trades. In the interview, they talk about the outlook for volatility and explain why higher volatility creates more opportunity to harvest the risk premium embedded in options prices.
They also explain why they prefer listed options to other types of derivatives on volatility, and provide insights on how they access liquidity in this market. To get the best price for the index options they trade, they use three methods of execution: working with banks that quote prices bilaterally, interacting with the electronic liquidity available in the Cboe order book, and sending quotes to the traders on the floor of the Cboe, where the exchange continues to support open outcry trading in S&P 500 options.
Lee, who is based in Minneapolis, directs the firm's research efforts and chairs the committee that oversees its investment strategies. He joined the firm in 2012, when it acquired his former employer, The Clifton Group. Berman, who has been with the firm for more than 10 years, is repsonsible for trading and operations at the firm's investment center in Westport, Conn. Prior to joining Parametric in 2006, he was a principal at Wolverine Trading, one of the largest options market-makers in the world, and was in charge of all trading at that firm's New York office.
MV: The first quarter was an extremely volatile period. How did that affect investor appetite for this kind of strategy, and how will that affect the returns going forward?
LEE: Part of what makes the first quarter look very volatile is that we were coming off a dormant volatility environment. That always tends to make those transitions look bigger than they would look in other periods. If I were to look at the first quarter broadly, I would say that type of volatility was maybe a little closer to normal than what we experienced in all of 2017 when volatility was extremely low.
How did it affect investor appetite for our strategy? It was an interesting period for volatility selling strategies in general. As you are aware, some funds did not survive that period of volatility. For those that were able to sustain through that transition from a low to a moderately high volatility environment and [that] were transparent about how their strategy performed and why it performed the way it did, the opportunity going forward is going to be better. In fact, our largest strategy, which combines holding equities and cash with selling index puts and index calls, performed very well from the peak of the equity market on January 26 through the end of the first quarter. And in the second quarter, we experienced very good returns from option selling.
As we often see after a transition of volatility, when you go through this period where realized volatility exceeds what was expected in the options market, the options market reprices and implied volatility gets much higher.
MV: Does that mean that the return to a more normal volatility environment improves the outlook for your returns, because there is more premium that you can potentially capture?
LEE: Well, what I would say is that the price we sell an option for is the most we’re able to earn. That sets an upper bound on the profit we can realize from the sale of an option. Now, that doesn’t mean we’re going to earn all of it, of course. We are establishing a liability the moment we sell an option. What we’re trying to do is keep as much of that premium as possible.
Generally, in a higher volatility environment, the upper bound for us increases. That’s one. Two, we index our position to volatility or target a likelihood of the option maturing in the money. All else [being] equal, the higher the volatility, the further out of the money we’re able to sell options. That means the range the market can move in before the options matures in the money is wider.
MV: As an institutional investor, you have access to many ways to get exposure to volatility. You can use variance swaps, you can use options on an ETF, you can even use options on VIX or the VIX itself. So what drives your decision to use index options as the preferred instrument for this strategy?
LEE: First of all, we’re interested in implied volatility versus realized volatility. In trading VIX or VIX options, we’re trading implied volatility versus implied volatility; recall the VIX index represents 30 day implied volatility. I’m not saying you can’t access the volatility risk premium in this manner, but it’s a different approach. We do use VIX futures on one of our strategies, but it’s important to understand the differences in the approaches.
Second, we’re a little concerned about variance swaps. First and foremost, I’m now entering a bilateral OTC trade, so I’ve got potential counterparty credit risk to consider. Second, variance is volatility squared. So when things go wrong, they tend to go wrong quickly.
We like index options because, a) they’re generally very liquid; b) they provide transparency; and c) they don’t introduce that idiosyncratic counterparty credit risk that we’re concerned about. And we can get good execution in that market. We feel like we can get a fair market and execute at a fair level, maybe even slightly better level if we find liquidity.
Those are the reasons that bring us to that market. We have found our clients take comfort in the fact that we’re dealing in listed markets that are more transparent, more liquid, [and] not locking them into potential risks that are more opaque.
Tracking a Global Index
MV: Historically, your VRP strategy was focused on the S&P 500 and the U.S. market. You’ve expanded the scope and applied it to international indices. First, which investors are interested in pursuing that strategy? And second, which indices are you tracking?
LEE: We are currently tracking a global index, the MSCI ACWI. It’s roughly 50% U.S. equity, 40% international developed equity, and the rest is emerging markets. That is our main global benchmark. Clients who are interested in that benchmark include U.S. clients who are starting to think about more of a global equity allocation, and European investors who are already in that frame of mind.
MV: In other words, institutional investors in Europe would be ripe for that kind of strategy because they’re used to benchmarking against the world index. Have I got that right?
LEE: That's right. When I’m traveling in the U.K., the Nordics or other parts of Europe, what I hear more frequently referenced as a benchmark is a global equity benchmark, not an international benchmark that would be, say, ex Norway or something.
MV: Coming back to the U.S. investors, if you’re offering a strategy that’s based on a global index, where half of it is actually U.S. stocks, wouldn’t some investors say, hey, I don’t want to double down on the U.S. piece. Why not just focus on an international index?
LEE: Well, I think you’re thinking of the partition of a domestic and an international portfolio. I’m describing investors who’ve already combined these allocations and just have a global portfolio. We’re finding, increasingly, U.S. investors who are thinking about that, and there are some consultants out there who are pushing their clients in that direction.
MV: Now, how do you implement that strategy? I imagine that it would be hard to find options on the MSCI ACWI, whereas you probably can find pretty deep markets for the options on the components.
BERMAN: Sure, I’ll jump in on that. You are correct that for the ACWI, the options are virtually non-existent. In order to get the exposure we’re looking for, we have found success with the MXEA and MXEF. Those are options on the MSCI EFA and the MSCI EM [indices]. Those are quoted and traded in the U.S. as listed options. We’ll go out to banks and put them in competition [to quote a price]. We've found great success with this approach.
LEE: We are also looking at a possible basket approach to this problem. We always want to have flexibility if, for some reason, liquidity dries up in a certain market, or if we run into capacity issues. Right now, we are focusing on a basket of some international equity index options that we could trade to deliver an EAFE option exposure. We haven’t done this yet, but it’s something we are researching.
Just to make sure we’re getting the best possible pricing for our clients, we do put the banks in competition to find the best execution level.
- Larry Berman, Managing Director, Parametric
MV: You say you go out to the banks to get a quote. Does that mean that your positions remain bilateral? Or do they go through the OCC for clearing?
BERMAN: No, these are OCC listed products, so there are two-sided markets available on the screens. Just to make sure we’re getting the best possible pricing for our clients, we do put the banks in competition to find the best execution level.
MV: In some markets, we're seeing the prop firms stepping forward as market makers willing to do block trades with institutional investors. Are you seeing that in these two index options products as well?
BERMAN: Not as much in those two names. But we are seeing liquidity grow in those products. So we are hopeful that we will see more participants in that marketplace.
MV: Going back to the options on the S&P 500, do you use the same approach there? Are you contacting banks to enter into negotiations, or are you interacting directly with the order book on CBOE?
BERMAN: In reference to the S&P 500, we approach the market on multiple fronts. Obviously, the screens are extremely tight, and there is good liquidity on the screens within our window that we’re trading, you know, the one month, two month, three month options. We like to keep the banks honest by, sometimes, quoting directly in the pit or quoting electronically. We mix it up to make sure that we’re getting the best possible execution for our clients.
MV: How has the balance changed over time between those three modes of execution?
BERMAN: Well, the electronic execution has gotten easier and easier as time has gone on. I do like the ability to trade electronically, like I said, to keep the banks on their toes. We also like going to the banks when we have a larger position to put on. I’m comfortable putting on very large size electronically, but there are also times when the banks come to us in the morning and say they have an axe, to buy or sell volatility, and it’s good to know that and put it into the decision of where we send the order flow.
Perspective on Liquidity
MV: With respect to liquidity, what changes have you seen over time? In the options markets that you use, has liquidity improved or deteriorated since the financial crisis?
BERMAN: Overall, volume is up across the board. There have been a few years where volume has basically flat lined. But in 2018, I think volume is trending higher. Second, the business has obviously become more electronic. We’ve seen some of the smaller market maker firms go away and the newer, well capitalized, technically advanced firms taking over. They are making bigger and faster markets and very tight markets. For our side of the business, I think it’s been an advantage.
MV: Some market observers have commented liquidity seems to be more fragile than it used to be. In other words, there is plenty of liquidity available during normal periods and then a drastic reduction during a period of stress. Do you find that to be true?
BERMAN: Well, I would agree with that up to a point. Liquidity can disappear quickly, but that’s no different than when we had open outcry markets. You may see markets widen out for two minutes, but they usually tighten quickly as the market makers sense an opportunity.
As a former floor trader, when there were times of crisis, we would ask the exchange to go into fast markets and the exchange would most likely grant us the ability to make a fast market, which meant we could widen our quotes out. That happens now where market markers, in a time of crisis, can widen out their books. The savvy market participant will not step in until the market has tightened back up.
Again, I don’t see a huge difference between open outcry and electronic when it comes to times of crisis. Because it was just as easy to walk out of a pit at a time of crisis as it is to widen out the markets on the screens.
MV: Does that apply equally well to the willingness of the banks to give you a quote?
BERMAN: I would say the banks are always willing to step up at a certain level, of course. It’s not like the old days, where they just wouldn’t pick up the phones. Back in the day, you could call a trading desk, and the phones just would keep on ringing. Now, with multiple ways to reach the desk, either electronically or through telephones or through Bloomberg, there’s ways to access liquidity.
MV: Are there other trends that you’ve observed for the last several years that are affecting the way you execute your trades or the appetite for what you are doing?
LEE: As I mentioned previously, we went through an extended period of very low volatility in the equity markets. If you look back through history, we’ve had low realized volatility before, but [this time around] it appeared in other asset classes. That raises the question of whether accommodative monetary policy around the globe set the table for this low volatility period, and if that is the case the reversal of that policy is going to lead to structural change in the volatility regime.
In the U.S., the Fed is well down the path of shrinking its balance sheet and raising rates. The ECB is not quite there, but they are getting there, they are starting to slow down the purchase of bonds. And, then, in Japan, at least they are doing less of it [quantitative easing]. If I’ve read my forecast right, the first quarter of next year will be the first time when in aggregate those central banks' balance sheets will begin shrinking.
In other words, one of the factors that dampened volatility for some time is going to start to fade away as the central banks begin to shrink their balance sheets and presumably we return to a more “normal” rate environment. So that could set the stage for a higher volatility environment than we have grown used to in recent years. But it’s hard to say for certain. We can only speculate, as you know.