Overview


Overview

The fundamental driving force behind any asset allocation methodology is risk management. Traditionally, asset allocation has been largely based on Modern Portfolio Theory which relies heavily on historical correlations. The significant drawdowns experienced by traditionally constructed portfolios during the Global Financial Crisis highlight the need for asset allocation and risk management techniques beyond Modern Portfolio Theory. Options-based asset allocation solutions are designed to allow investors to preserve performance while mitigating risk without an overreliance on the expected benefits of diversification based on historical correlations.

The primary focus of my research has been the use of options to alter the return and risk profile of portfolios across a wide variety of asset classes. In addition to applying options-based strategies as a fundamental part of asset allocation methodologies, options-based approaches can be applied as overlays allowing managers to make security selection and asset allocation decisions autonomously while still providing risk controls.

The popularity of options use in actively managed portfolios continues to grow. It is imperative that financial institutions are equipped with a thorough understanding the characteristics of options-based strategies and the benefits that they can and cannot provide, particularly in an environment of elevated systemic risk in which historical correlations may have limited relevance in assessing future tail risk. Such understanding is also critical to financial regulators working to quickly identify fraudulent managers who are reporting unrealistic performance.

It should also be noted that options-based strategies can be used as substitutes for traditional strategies such as risk parity. One of the significant benefits of an options-based risk parity approach is that it can allow a manager to make asset allocation decisions independently of the risk weighting of asset classes by directly altering the risk profile of each asset class.

When used in an indexed annuities framework, options can reduce path dependency of investment strategies.

Options-based strategies and synthetic options-based strategies can also be used as liquid alternatives to a variety of alternative investment strategies by providing similar return and risk profiles without the typical structural or security-based illiquidity.

Finally, signals provided by option-market data can be used to identify insider/informed trading and provide a framework for algorithmic security selection.