QVR’s Benn Eifert continues to be the best translator of options to normie speak. All of his podcast interviews are full of useful knowledge about options and asset management practices.
His latest appearance on Odd Lots is no different.
I excerpt my favorite parts with my emphasis at times.
1. Buffer ETFs and the Related Structured Product History (UConn Story & Cost of Predictability)
Question: I saw a headline float by about the University of Connecticut’s endowment dropping some of its hedge fund exposure in favor of buffer ETFs. What are buffer ETFs?
Benn Eifert: “So this is a big new manifestation of a relatively old popular idea. So buffer ETFs are usually pitched as sort of defined outcomes in some sense over some time period where they say, well, what you’re trying, what we’re trying to do is give you equity exposure, but you have protection, you have a buffer down to say 10 or 15% where you’re not gonna lose money as the market goes down. And then beyond that point, you’re exposed. And in order to do that, you’re gonna sell an upside call, you’re gonna give up some of your upside. And so what this is, it’s basically just a put spread collar, which is a very standard kind of option structure where you sell a call to buy a put spread that is for many, many years and decades by far the most popular thing that a Wall Street derivative salesperson will run around trying to pitch to their clients.”
One thing I don’t get is like, why would you prefer doing that versus just buying a bunch of equities and maybe hedging in a more traditional way like buying some bonds?
Benn Eifert: “So this is exactly the right question. So the first thing that, you know, a derivatives person looks at when you look at a trade like this is, okay, what does this do to the delta, the equity exposure of your position, right? So if you buy some equities, that is a one delta—a derivatives guy would say it’s just a delta one position. Market goes up a percent, you make a percent. If you trade a typical put spread collar against that, you buy a put spread, you sell a call, you’re probably gonna take that one.
And so if you do that kind of a trade, you might take your one delta option down to like a 0.6—down to a 60 delta. So now you’re only participating kinda 60% in the movements of the market. And if you look at how these kinds of trades perform over long periods of time, they actually act a whole lot just like having sort of 60% as much stock, right? Because ultimately they’re rolling these—it’s not really like a buy-and-hold-to-maturity thing. It’s like they’re rolling these options to kind of maintain this kind of exposure. And if you were just to take the counterfactual, which is why don’t I just own 60% as much stock and put 40% of the rest in T-bills? Turns out your fees are way less and your performance is probably better.”
Are there institutions, you know, Tracy mentioned the University of Connecticut… are there certain types of institutions where this is in alignment with the institutional mandate?
Benn Eifert: “So there are cases when that’s to some extent true, at least with some kinds of derivative structures. So you’ll have cases where there’s like a big disbursement that has to be made at some future date and they wanna lock in for sure the fact that they can make that disbursement, but usually something more like an outright put is gonna be a better match for that. Right? ‘Cause the thing about the put spread or the put spread collar is you’ve only got like this say 10% buffer of protection, and what if the market crashes?”
So this, if the stock falls or if the market falls 25%, which does happen, you are actually not protected against all of that.
Benn Eifert: “Yeah, exactly right. Yeah. So this stuff really doesn’t lock in defined outcomes to the downside. It just gives you kind of some buffer of protection in exchange for some upside that you’re losing.”
You touched on this earlier, but talk to us a little bit more about the commissions and the execution and whether or not you’re getting a good deal on those.
Benn Eifert: “Yeah, no. So this is a really important point. Generally, these are not always, but typically these kinds of structures exist in fairly popular, fairly liquid underlyings, right? This isn’t like micro-cap stocks, this is S&P or something. So the bid-offer spreads don’t look that wide when you look at it. But you have to keep in mind if you have a $22 billion fund that once a quarter is rolling this giant collar and everybody knows about it and knows exactly what you’re gonna do and knows exactly when you’re gonna do it, then obviously the market just moves right ahead of you, right? And everybody positions for this trade that you’re gonna do.”
[Moontower take: this is well-aligned with my broad view that the inputs into an option price mean they are surgical tools — they are highly levered to the specific inputs. Strategies which use them with little discernment as a blunt instrument are poorly matched to why they’re useful at all. I wouldn’t die on that hill because I can imagine a very good argument for using them in a systematic way but the details matter and my point would be that the argument would indeed need to be very good to overcome my prior. The hooker asset management world often just sees a new trick where they can hide behind “I’m giving the customer what they want, that’s capitalism” but generating demand by playing framing games is zero-sum. Of course I’m biased, every time a person who makes their money in marketing outbids an option trader for a house my pen gets saltier.]
2. Benn’s favorite blow-up story
I think possibly my favorite was Allianz’s Structured Alpha, which blew up in 2020 in March. And the reason was, you know, Allianz is a huge sort of safe conservative firm that everybody would look at and say, ‘Oh, they would never be doing something kind of crazy, right?’ Because it’s, you know, they’re very buttoned up, they’re very serious people. They own PIMCO, and so they—but they had these French kind of option traders…”
(Joe Weisenthal chuckles at “French.”)
Benn Eifert: “Yeah, it’s always the French. There’s just something in the DNA.”
“And, you know, they were doing something where they would effectively, they would usually sell downside put spreads—they’d sell a put, and then they’d buy back a lower strike put. That was the main thing. They’d do a few other things, but like, think of that as the core thing they were doing. Right? And that’s kind of safe-ish, right? You’re getting some credit, you’re earning some premium, but like, you’re supposed to know how much you can lose.”
“And then—but the returns were pretty good. They actually kind of kept up with equity markets, which doesn’t really make a whole lot of sense. And it turned out the way that they were doing that was that they were just not buying back the downside put—or they were buying it back but like way, way, way lower strike than they said they were buying it back.”
Joe Weisenthal: “Oh, that sounds really bad.”
Benn Eifert: “Yeah, that was really bad. And they were doing that for years and years. And it’s actually really great—there’s a whole SEC complaint about this. You can read all the details. They had to show this to investors, what they were doing, right? Because that’s part of the business. And so they had spreadsheets with all these hardcoded cells and made-up numbers to sort of be able to lie to investors and say that they were doing what they said they were doing, when they weren’t.”
“And because that’s complicated to manage—to have all these big spreadsheets faking your returns and faking your risk and everything—they actually had a Word document with an 18-point list on how to do all of the lying for all their analysts to be able to follow. And, you know, instructions on how to not hover your mouse over a formula… because the investor might see that the number was hardcoded instead of a formula.”
“They didn’t have some sophisticated methodology for this. They literally just typed the numbers into the spreadsheet.”
Joe Weisenthal: “You don’t even need to be French to do that.”
Benn Eifert: “That’s right. You just go to cell C6 sometimes and you just overwrite the number.”
“So what happened was they sold lots of VIX calls with the front-month futures at about 25. And then the front-month VIX futures went to 85. And so they were liquidated in the middle of March in a huge catastrophic explosion that people like us were shown in an auction and everything. And they drove the relative price of VIX options and futures to twice as high as it had ever been relative to S&P, in this sort of spectacular implosion.”
“They went to zero. They lost billions and billions of dollars for teachers’ pensions and all this kind of stuff in just total and utter fraud. Again, at a very big buttoned-up place.”
“And actually, one of the funny takeaways from it was, in all of the lawsuits, you know, Allianz stepped up and settled lots of lawsuits and paid investors back—you know, all this money, and it cost them many billions of dollars. And so actually, in a twisted sort of way, the logic of investing with the big safe place actually worked but it wasn’t because they managed the risk or had any idea what these guys were doing. It was just that you could sue them, and they would pay you.”
3. The History of Option Selling: Good Until It Got Popular
Benn Eifert: “So from 1990 to about 2012, they look pretty good. They kind of keep up on average with the S&P but on somewhat lower volatility with a little bit lower drawdowns.”
“Option selling looked good when nobody was doing it in size, right? Option markets were a backwater. There were funny little things that a few hedge funds did, and a few kind of people, but there were no giant pension, $200 billion pension funds doing option selling. And then those pension fund consultants started writing white papers and they started pitching to their clients’ boards, and by like 2011, 2012, 2013, they started to get some traction. And you started to have, you know, giant $200 billion pension funds saying, ‘Sure, we’ll put 10% of our assets in, move it from equity into option selling.’ And that grew and grew and grew and grew and grew.”
“And what happened was you see that performance then—in kind of the out-of-sample period, if you wanna think of it that way from a back test—yeah, for BXM and PUT index, which are the benchmarks for this kind of stuff, then really deteriorated relative to S&P where they sort of had very similar risk but much less return.”
4. How to Start Using Options Carefully
Benn Eifert: “Usually the first thing that I do is I send people a thread that has a collection a lot of people contributed to on good reading material and stuff.”
“And then, you know, the next thing that I tell people is what do I think are kind of reasonably safe uses of options that if you really want to dedicate time to figuring this out, you might kind of start with, right?”
“If you want to be really thoughtful about options selling, you know, to try to generate yield over time, there’s ways to do that too. But you really have to read up to understand how to think about the risk-reward of a trade that you’re doing—not just believe there’s something you can do all the time because somebody told you it’s a great idea.”