Can investors refine portfolio rebalancing while capturing a volatility risk premium (VRP) by systematically shorting options matched to target allocations of the underlying asset? In their October 2017 paper entitled “An Alternative Option to Portfolio Rebalancing”, Roni Israelov and Harsha Tummala explore multi-asset class portfolio rebalancing via an option selling overlay. The overlay sells out-of-the-money options such that, if stocks rise (fall), counterparties exercise call (put) options and the portfolio must sell (buy) shares. They intend their approach to counter short-term momentum exposure between rebalancings (when the portfolio is overweight winners and underweight losers) with short-term reversal exposure inherent in short options. For testing, they assume: (1) a simple 60%-40% stocks-bonds portfolio; (2) bond returns are small compared to stock returns (so only the stock allocation requires rebalancing); and, (3) option settlement via share transfer, as for SPDR S&P 500 (SPY) as the stock/option positions. They each month sell nearest out-of-the-money S&P 500 Index call and put options across multiple economically priced strikes and update the overlay intramonth if new economically priced strikes become available. Once sold, they hold the options to expiration. Using daily S&P 500 Total Return Index returns, Barclays US Aggregate Bond Index returns and closing bid/ask quotes for S&P 500 Index options equity options (with returns calculated in excess of the risk-free rate) during 1996 through 2015, they find that:
- Without option overlay over the sample period, the 60%-40% portfolio has:
- For monthly rebalancing, 5.12% annualized gross excess return and 9.81% annualized volatility, with annualized gross Sharpe ratio 0.52.
- For daily rebalancing, 5.23% annualized gross excess return and 9.85% annualized volatility, with annualized gross Sharpe ratio 0.53.
- The option overlay as modeled has:
- Average maturity about 15 days.
- Average face value about 6.7% of the portfolio equity allocation.
- Beta about -0.22 to the stock return since the last portfolio rebalance.
- 0.11% annualized gross excess return and 0.26% annualized volatility, with annualized gross Sharpe ratio 0.42.
- With option overlay over the sample period, the 60%-40% portfolio has 5.23% and annualized volatility 9.92%, with annualized gross Sharpe ratio 0.53. Improvement over the monthly rebalanced 60%-40% portfolio comes about equally from VRP capture and from avoidance of a small negative momentum return.
- However, option overlay trading frictions are about four times higher than (about the same as) those of a portfolio conventionally rebalanced monthly (daily).
In summary, evidence indicates that automating portfolio rebalancing via an out-of-the money call and put option overlay is feasible but does not much improve overall portfolio performance.
Cautions regarding findings include:
- Precise selection/sizing of a rebalancing option overlay is likely beyond the reach of many investors. A less precise approach may still have value.
- Cash-settled equity index options capture VRP but would not automate equity position rebalancing trades.
- The option overlay may have tax implications.
