I have been writing about liquid alternatives as tools for smoothing out the ride over a full market cycle for many years. Initially when I started blogging, the term liquid alternatives did not exist, I referred to them as diversifiers. Used correctly, diversifiers can help avoid the full brunt of large declines thus smoothing out the ride.
The cautionary point at a high level is that the stock market has always been the best performing asset class while diversifiers tend to have a low correlation to equities or be less volatile than them so as a result diversifiers underperform equities over the long term. Sizing diversifiers into a portfolio should be done in moderation to manage the volatility and correlation of an equity based portfolio. Too much exposure to alternatives and you have portfolio of diversifiers, hedged with a little bit of equity that will underperform over the long term.
Whenever the next bear market starts I will increase client exposure to diversifiers and so I am always studying funds that offer alternative strategies. That brings us to the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW). The single act of buying a put option (so not as part of a combination) is a bearish bet, a bet that the underlying stock or index or anything else will go down. That also makes buying a put a hedge against a decline in the underlying stock or index or anything else. Selling a put option (or writing a put option) then is a bullish strategy or at least a neutral strategy (the seller benefits if the stock goes up or stays where it is). The ideal outcome when you sell a put is that it expires worthless and you keep the premium. If the stock goes below the strike price of the put then you will be assigned and buy the stock at the strike price and in that scenario you'd be a little under water.
If you sell a put, it should be on a stock that you are willing to own. An investor wanting to buy 200 shares of IBM could buy 100 shares and sell a put option below the current market price which in effect is putting in a limit order below the market which is like getting paid (the premium) to place the limit order.
Where this can go wrong is selling a put right before a large decline. In the middle of 2007, Citigroup was trading at $55. An investor could have sold a put option with a strike price of $55 going out six months and probably brought in $2 in premium which is a good number in percentage terms. Six months later though, Citi was at $28. This investor then would be paying $50 for a stock trading at $28, on its way much lower. Too much of this results in a permanent impairment of capital. The adverse price movements for put sellers was far worse with internet stocks in 2001 and 2002 as stocks were dropping from $300 to less than $100 in just a couple of months.
PUTW sells at the money puts on a monthly basis, against the S&P 500. The fund started trading in early 2016 and since inception it is up about 15% versus 39% for the S&P 500 Index (both numbers per Google Finance). The dividend yield, the actual dividend, has been quite modest but the fund has also paid out capital gains, so anyone interested in the fund with a choice of accounts might want to consider allocating to an IRA versus a taxable account.
For however much longer the bull market lasts, I imagine PUTW would continue to march higher but with the expectation of continuing to lag the S&P 500. Lagging the index is not a negative insomuch as selling puts doesn't capture upside it only benefits from it.
Spelling it out that way, doesn't capture the upside but does participate in the downside (as outlined above), makes put selling potentially unattractive. I wouldn't quite draw that conclusion, more like it is not a strategy for all times. Selling put options after an almost nine year bull market is more likely to lead to an outcome akin to selling the $50 puts on Citi in 2007.
A better time to start selling would be after a large decline in the market not before it. That is where we are now, before a large decline. That's not a prediction of when the next large decline will occur but a realization that put selling is far more vulnerable to high markets, much less so to low markets.
At this point I don't know whether I would add PUTW for clients the next time the market drops a lot, it depends on the nature of the decline which is unknowable but I am interested enough to consider it. It wouldn't be a great equity proxy but could help smooth out volatility...after a large decline.