The Quarterly Statement: Q1 2017

April 17th, 2017


Market Commentary

The start of 2017 was a stark but welcomed contrast to the prior year. In January 2016, U.S. markets experienced one of their worst starts in history ― hampered by concerns of slowing global growth, bottoming oil prices, and an impending election season. This January, these worries seemed far from investors’ minds. Domestic and international markets took economic and political news in stride, shrugging off uncertainty as most regions, asset classes, and sectors generated positive returns for the quarter.

Strong positive sentiment clearly played a large role in the market’s uptick this quarter, including the Conference Board’s U.S. Consumer Confidence Index hitting a 16-year high. Underlying “hard” economic data also buoyed this positive trend following supportive manufacturing reports and increased corporate profits.

This economic strength led the Federal Reserve to raise the federal funds rate at its mid-March meeting on the back of compelling employment and CPI data. While the rate increase was expected, the FOMC’s “dot plot” showed little change in the March committee meeting and was perceived as dovish. This contributed to a flatter yield curve over the quarter as short-term interest rates rose and longerdated maturities fell quarter-over-quarter (Exhibit 1). For the remainder of 2017, markets expect two additional rate hikes with the next likely action in June.

Rising rates did not dampen equity returns this quarter, but of note was the abrupt reversal in market leadership. Growth stocks experienced an unparalleled run after the 2008 financial crisis up until 2016, when value outpaced growth by 10.3% on a rolling 12-month basis. Yet year-to-date growth has rebounded, and this metric has fallen back to 3.5% (Exhibit 2). This outperformance is apparent domestically, internationally, and at the sub-asset class level. In particular, domestic large and small cap growth indices outperformed their value counterparts by more than 5.5%.

More pronounced was the outperformance of international and emerging equities this quarter ― the MSCI World Ex-U.S. and Emerging Market Indices gained 7.9% and 11.4%, respectively. Muted geopolitical uncertainty contributed to stability in Europe, following Dutch election results and the falling odds of a populist French election outcome in May. Economic data remained strong in the region, with healthy CPI data reported in March and the Eurozone PMI reaching a 70-month high. Emerging market economies benefited from news of accelerating earnings and a narrowing growth gap relative to developed economies.

Another development in equities on a global scale this quarter was a substantial drop in correlations between securities. As seen in Exhibit 3, correlations on a global basis have reached levels not sustained since the tech bubble burst in the early 2000s. This should provide active managers with better opportunities to add value through sector allocation and stock selection.

Capturing the Volatility Risk Premium

In the first quarter of 2017, domestic equities demonstrated a convincing continuation of the current bull market, which is the second longest expansion since World War II. As the market’s run passed an 8-year milestone in March, those searching for differentiated returns might consider looking beyond traditional equities to optionsbased strategies that may provide long-term return potential with less market risk than long-only equities.

An approach that has historically provided competitive returns similar to the S&P 500 with less variability is writing put options against the S&P 500. A put option’s payoff pattern will depend on whether it is viewed from the perspective of the buyer or seller. The buyer pays a premium for the right to sell a security at a predetermined (strike) price within a certain time frame, which is analogous to purchasing insurance. The writer (seller) collects the premium paid and assumes the responsibility of purchasing the security if the buyer chooses to exercise this right. Consequently, the seller of a put option profits the most when she can simply collect a premium and the option contract expires worthless.

The following chart shows how using options in this fashion can work. Exhibit 4 compares the Chicago Board Options Exchange (CBOE) S&P 500 PutWrite Index and the S&P 500 Index over the past 30 years on a 5-year rolling average basis. During this period, the PutWrite Index traded within a narrower band. Perhaps more remarkably—over the worst 5-year period from February 2004 to February 2009, the PutWrite Index was flat while the S&P 500 lost 7% (annualized) over the same time frame.

How did this strategy work? When utilizing put options, underlying factors and sources of return must be considered. One element often overlooked is the cost, or price, of the option. The absolute value of the premium paid or collected is a function of the expected future price of a security and depends on a variety of factors:

  • The strike price relative to the market price of the security at the time of initiation: options that are further out of the money will cost less.
  • The amount of time until option expiration: the longer the amount of time the holder has to potentially exercise the option, the higher the premium.
  • The implied volatility of the market: the higher anticipated fluctuation in price, the higher the premium.

The last of these factors, implied volatility, can be the most important component of an option’s price. When analyzing the implied volatility embedded in S&P 500 option prices versus the realized volatility that actually occurred in the market for the S&P 500, there is a noticeable mismatch over time. That is, the implied volatility embedded into option premiums has overestimated the actual S&P 500 price swing nearly 86% of the time at an average rate of 4% per annum over the last 5 years (Exhibit 5). This trend is stable over longer time periods as well, averaging 4% over the last 30 years.

This difference between realized and implied volatility is referred to as the volatility risk premium and reflects the notion that investors may be willing to overpay for the protection offered in the purchase of put options. While a manager cannot control the market’s trajectory, one can employ various option selection strategies outside of those used in the CBOE index to capture the risk premium and potentially generate additional excess return.

The two levers that a manager can most easily control include the strike price and maturity selection. By proactively selecting a higher or lower strike price with a shorter or longer maturity profile, active managers may have the opportunity to add excess return over the CBOE Index. For instance, selling put options with higher strike prices theoretically increases upside participation in the market and generally provides a higher premium to the seller, but provides less downside protection.

The volatility risk premium is roughly analogous to a variety of risk premiums; for example, a credit risk premium for lower credit quality bonds, a liquidity risk premium for capital that is tied up for an extended period of time, or even a geographic risk premium. The ability and intent to capture these premiums may be exploited by active managers willing to do the research. But the volatility risk premium, in particular, may serve as a differentiated and complementary source of alpha.

If interested, this topic will be discussed in greater detail by Sean Heron, a GIM Portfolio Manager, at the CFA Institute’s 70th Annual Conference in Philadelphia on Monday, May 22.


THE QUARTERLY STATEMENT is a Glenmede newsletter written by
Peter J. Zuleba, III, President of Glenmede Investment Management



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Opinions represent those of Glenmede Investment Management, LP (GIM) as of the date of this report and are for general informational purposes only. This document is intended for sophisticated, institutional investors only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIM’s opinions may change at any time without notice to you.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. It may contain information which is not actionable or appropriate for every investor, and should only be used after consultation with professionals. References to risk controls do not imply that all risk is removed. All investments carry a certain degree of risk. Past performance of any strategy, area or security is not indicative of future performance. Information contained herein is gathered from third party sources, which GIM believes to be reliable, but is not guaranteed for accuracy or completeness.