by Mike Schnitzel.
The Lipper Options Arbitrage/Strategies Funds classification are funds that employ various strategies to capture the spread between similar options through inefficiencies in the market or funds and use portfolio strategies where the manager focuses on options to generate the bulk of the portfolio’s return.
The Lipper Leaders Rating System is a toolkit that helps guide investors and their advisors in selecting funds that suit individual investment styles and goals. According to LSEG Lipper, “Each fund is ranked against its peers based on the metric used (such as its flagship risk-adjusted return measure, Consistent Return, Total Return, or Expense), and the highest 20% of funds in each peer group are named Lipper Leaders, the next 20% receive a rating of 4, the middle 20% are rated 3, the next 20% are rated 2, and the lowest 20% are rated 1.”
Using Lipper Leader metrics for the month ended March 31, 2023, one of the best Lipper Options Arbitrage/Strategies Funds is the Glenmede Funds Global Secured Options Portfolio (NOVIX). The fund has a 5 in Consistent Return for the three- and five-year time periods and has beaten its MSCI All Country World Index benchmark over the one-year period. We spoke with portfolio manager Sean Heron to examine the strategies he uses to manage the fund, and his longer-term outlook on trends and important issues for the Options Arbitrage/Strategies Funds classification.
Using consistent, efficient strategies to deliver in volatile markets
Heron said the key to his fund’s consistent returns is to make sure the source of the return is delivered efficiently and in a repeatable manner. He said NOVIX’s returns need to have “shock absorbers,” and selling options at premiums creates that shock absorber, which he said acts as a liquidity buffer during times of stress.
Additionally, managers have to combat the desire to oversimplify portfolios during times of market volatility, which causes liquidity to gather around the S&P 500 in these times of distress. Options expire and need to be replaced, Heron noted, so managers need liquidity to be able to execute the best possible strategy at the proper time.
“So, when the market rallies everyone is buying downside protection and sacrificing upside returns. Everyone sells away their protection and starts buying upside returns,” Heron said. “By not capping your upside and allowing for recovery you are getting better returns and smoothing volatility. Liquidity helps.”
Another way that Heron and his management team manage risk is to never use leverage in his fund. He said this helps to smooth out returns rather than cause the type of volatility that can drive investors to sell their shares. Heron called investors sticking with his fund over the long-term one of the cornerstones of NOVIX’s management philosophy.
Gaining exposure, focusing on liquidity
Heron said his fund having a global bent gives him an advantage over funds that focus solely on the U.S.
“I have flexibility to sell puts, writes, and covered calls on U.S. and global indices. I create a sandbox plus or minus one standard deviation to the indices,” Heron said. “A key [to my strategy] is I am never leveraged and am fully vested.”
Heron attempts to gain exposure to volatility premium and equity risk premium as much as possible. “What I’m trying to do is identify where the arbitrage is—identifying it between one option versus another—identify the option buying demand and avoid the option selling pressure. We’ll sell an option and may buy it back, but we always stay in the sandbox.” He said NOVIX allocates its portfolio assets to the S&P 500 (40%), Russell 2000 (10%), MSCI EAFE (40%), and MSCI Emerging Markets (10%). “We try to stay within 2-3% of the benchmarks so there is not a lot of tracking error, but we offer some premium. People want to get what they sign up for.”
Heron said the issues he is focused on over the next few years are current events and liquidity demand. “Derivatives have a recency bias—what has happened in the recent past affects pricing of options,” he said. “Volatility sellers are at an advantage for the next few years because of the pandemic.”
The demand for liquidity is only going to continue to increase over the next few years, according to Heron. “When you have low interest rates there is plenty of liquidity, but when they get raised you start losing liquidity and it becomes more of a quality that is desired by investors,” he said. “I think liquidity will be more valued over the next several years because you need an efficient asset to capture return or risk premium.”
NOVIX helps diversify a portfolio with volatility risk premium exposure
What is generally missing from most portfolios is volatility risk premium, according to Heron. “Simply by adding put writing you add volatility risk premium in an efficient way and if we can add alpha to that, that is the icing on the cake.” Current compensation for risk, according to Heron, is below the historic average but the volatility risk premium is higher. “You are looking at high single-digit return in a class that has 60% the risk of equities,” Heron said.
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