Alpha Generation

Something I have discussed at a number of the Montreal Exchange Option Education Days is the theory that markets are efficient, which is to say the stock market is a pricing mechanism where investors come together to evaluate potential return. You buy shares when you believe them to be undervalued and sell them because you think that they are overvalued.

The concept of efficiency rests with the belief that a large collection of buyers and sellers are making decisions on the basis of known, available information will establish a fair market value. That does not mean the end value is correct, only that it is based on rational expectations across a large contingent of investors using real money to establish positions.

The options market works much the same way, except that it evaluates risk rather than return. You write options if you believe that the volatility being implied is too high and you buy options when implied volatility is understating future risk.

A third component of this discussion is an understanding of the term “alpha” which is a concept that quantifies return relative to risk. Theoretically, every point on the risk scale has an attendant rate of return… i.e. higher risk begets higher return. When the return is greater than what is expected for a given level of risk, you have generated alpha or stated another way you have delivered superior risk adjusted returns.

Alpha is a core tenet in the financial industry. Institutional money managers are constantly being evaluated on their ability to produce excess risk adjusted returns; more so in the hedge fund industry where long short strategies incorporating leverage attempt to produce high real returns at coincidently high levels of risk. When it works, the numbers are compelling; when it doesn’t, the fallout is severe.

Unfortunately, risk adjusted return is rarely discussed among individual investors because most have no grasp about the mathematics of risk. Individual investing is more art than science, where decisions are usually the result of gut feelings rather than mathematical precepts.

The trick is to utilize strategies that can be adapted to efficient markets without having to earn a degree in calculus. Hence my preference for a systematic strategy of writing calls against broad based indices. In theory, if one links an unlevered index, that efficiency prices potential return to an option that efficiently prices risk metrics you should generate alpha. A position that has been borne out by the long-term performance of various covered call writing indices.

Writing covered calls against broad based indices, like the iShares S&P TSX 60 index fund (TMX: XIU) or the S&P 500 Depositary Receipts (NYSE, SPY), has generated superior risk adjusted returns than one would get by simply holding the underlying index. Evidence of this can be found in the risk adjusted returns from inception for the Mx Covered Call Writers Index when compared to a buy and hold position on XIU.

For the uninitiated, covered call writing involves the simultaneous purchase of the underlying index ETFs and writing short to medium term at-the-money calls. For example, a covered call would involve the purchase of XIU at $19.91 per share (Friday’s closing price) with the simultaneous sale of ,say, the XIU March 20 call at 25 cents.

By selling the March 20 call you have agreed to sell the XIU shares at $20 anytime between now and the third Friday in March, which is the date the option expires. If the stock is sold at $20 per share, your net return is 1.7%. If the stock remains the same, you keep the 25 cent premium and your net return would be 1.25%; the 25 cents provides some downside protection to $19.67 per share.

So in three out of four scenarios you are ahead of the game writing the covered call. If the stock rises slightly, stays the same or falls you are better off having written the covered call than simply holding the underlying ETF. Only if XIU rises dramatically do you underperform the covered call strategy. Indeed, that is the underlying strategy that is measured by the Mx Covered call writers index.

Still, covered writing indices which measure the performance of selling at-the-money calls against broad based indices, do not substantiate efficient market theory. I say that because writing covered calls against individual stocks has produced no evidence supporting the efficiency of markets. In fact, writing covered calls against individual stocks does just the opposite.

That seeming disconnect is grounded in logic. Whereas the options market is pretty good at evaluating market risk it has never been able to efficiently quantify company specific risk factors. These so-called systemic risks typically drive individual stock prices but are theoretically diversified away within a broadly based index.

So much for long term history! More recently, broadly based equity indices representing the market have themselves been difficult to evaluate. Financial markets have succumbed to crowd psychology as investors try to evaluate macro events at a time when central bank liquidity injections have blurred fundamental economic tenets.

As one might expect, we are witnessing this play out in the performance of covered call indices. Over the past ten years, for example, the Mx Covered call writers index has returned 4.31% compounded annually versus a compound annual return of 5.52% for the XIU buy and hold strategy. Still, when you divide excess return less the risk free rate by the standard deviation of the respective strategies, the risk adjusted results are very similar.

More striking is the pockets of disparity among the two strategies. Since the MCWX index holds XIU as the underlying equity, you would expect it to correlate closely with the returns from a buy and hold strategy where one holds XIU and does not write covered calls.

But in the last three years we have witnessed some unusually large gaps between the two strategies. In 2011, for example, the MCWX Index lost 0.42% compared to a loss of -11.51% in the XIU buy and hold strategy (note we are not including dividends in these performance calculations). Same with 2013, where the MCWX generated about a third of the return that buy and hold produced, which in percentage terms was the worst year of underperformance since inception.

I suspect these gaps are fallout from quantitative easing that has distorted the normal metrics that drive economies and which are ultimately reflected in broad based equity indices. In short, these outside influences are difficult for the option market to quantify.

If these assumptions are correct, then 2014 may be a transitional year. As central banks gradually withdraw liquidity, financial markets will likely revert to normal pricing metrics which can be more efficiently valued by the options market. In essence creating a scenario where the index based covered call strategy once again leads the way in the generation of alpha.