ETFs and Putting a Collar on Risk

Academics use ETFs to prove collars work.

May 8, 2012

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Dog collar CIRIn 2008, the darkest days of the Financial Crisis, Canadian pension fund assets plunged by -15.6% as the S&P/TSX Composite Index fell -33.0% and the MSCI World Index dropped -25.8%. Volatile performance in equity markets (combined with historic lows in interest rates) has also driven many plans down the derisking path as they embrace long bonds, liability-driven investment strategies and slow and steady alternatives like real estate and infrastructure.

However, according to new data from a couple of U.S. researchers, finding an alternative to equity market risk could be a lot simpler than hunting for the best bridge or toll road to invest in. Why not try a collar strategy instead? Edward Szado and Thomas Schneewies (who also happened to be a speaker at the 2011 Investment Innovations Conference) have found that options-based collar strategies would have outperformed the market in most asset classes while drastically reducing risk in the lead-up to the financial crisis (not to mention the recovery that followed).

Collar strategies are actually a pretty simple proposition – they’re created by purchasing out-of-the-money put options while simultaneously writing out-of-the-money call options to lock in gains and add protection for when markets go south.

Szado and Scheewies use ETFs to prove their point, showing how collar strategies would perform across a range of ETFs including equities, commodities, fixed income, currency and real estate. The collared approach outperformed all ETFs except a few – Australian dollar and Japanese yen currency ETFs, two bond ETFs and Nasdaq and gold ETFs. These ETFs were negatively correlated to assets worst hit by the financial crisis and, as such, outperformed the collar strategies.

For the rest, however, the collar strategy provided drawdown protection in all cases. Returns, however, were mixed as the authors note:

Collars tend to outperform in cases in which drawdowns are more aggressive than run ups. The implied volatility skew can significantly impact collar returns. The ETFs presented in the analysis exhibit a mix of put skew and call skew, affecting the relative tradeoff between downside protection and the sacrifice of upside participation.

Szado and Schneewies are quick to point out collar strategies are no silver bullet for all products and market conditions. However, they do offer significant risk reduction especially in volatile markets.

These findings open up some interesting possibilities for using ETFs, especially when combined with a simple collar strategy. That could make it a lot easier for investors of every stripe to create a better ETF portfolio, drawing on sophisticated tools for risk reduction and improved returns in volatile times. Read the full paper.

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