SPS Funds
Innovative Investment Vehicle for Low-Risk Tolerance Investors
About Our Funds
"...if you do decide to alter your portfolio from market weightings, you can do so with much less risk if your active bets are made around a core portfolio that is broadly indexed." – Burton G. Malkiel
S&P 500 and Nasdaq 100 are the most widely tracked indexes gauging the U.S. stock market. Part of the reason why the two indexes are so popular is their proven performance. However, their historical volatility is untenable for low-risk tolerance investors such as older Americans near or in retirement. For instance, both indexes lost more than 50% in value in the Great Recession Period of November 2007 through February 2009. Therefore, the plain vanilla S&P 500 and Nasdaq 100 index funds must be more suitable for those with a limited investment horizon. The reason is that portfolio exposures to fat-tail events, such as the one in the Great Recession period, would devastate their financial security. Therefore, controlling the tail risk of retirement asset portfolios is a matter of survival.
Description and Objective
Stable Plus Shares ("SPS" hereafter) funds are options overlay index ETFs/SMAs. SPS funds' assets comprise an index constituent equity portfolio and a tail risk hedge portfolio comprising overlaying option spreads. The SPS fund family has five members: Stable S&P 500 Plus ETF, Stable Plus Nasdaq 100 Plus ETF, Stable 0-3 Month Treasury Bill Plus ETF, Portfolio Stabilizer Plus SMA, and Virtual Annuity ETF/SMA.
SPS funds aim to assist those with low-risk tolerance or a limited investment horizon, particularly older Americans, in reaching financial security and improving their well-being. The funds seek to outperform the tracking benchmark indexes in absolute return on an annual basis, curtail the tail risk of the benchmark indexes, and provide monthly income. SPS funds are the first-ever options overlay index funds to attempt to surpass the tracking benchmark index in absolute return. In contrast, the existing options overlay funds seek to provide regular income or enhance risk-adjusted returns.
Comparison with Other Options Overlay Funds
The following table compares the SPS funds and other major options overlay funds.
Backtest
In this section, we evaluate the historical performance of the Stable S&P 500 Plus and the Stable Nasdaq 100 Plus along with their benchmark indexes for 27 years from 1990 to 2022, and that of the Stable Small-Cap 600 Plus along with its benchmark index for 22.5 years from 7/2000 to 2022. The performance of the three SPS funds for more than two decades would provide reliable evidence for or against their effectiveness in outperforming their corresponding benchmark index in absolute return and curtailing its tail risk.
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Risk and Return Attributes
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The table below presents the risk and return attributes of the three SPS funds and their benchmark indexes. According to the table, the SPS funds significantly outperformed their benchmark indexes in absolute return in the sample period. To be specific, the SPS S&P 500, the SPS Nasdaq 100, and the SPS Small-Cap 600 made a geometric (arithmetic) mean monthly return of 1.04% (1.15%), 1.25% (1.51%), and 1.12% (1.30%), respectively, compared with 0.78% (0.87%), 0.99% (1.23%), and 0.72% (0.89%) for S&P 500, Nasdaq-100, and S&P 500 SmallCap 600, respectively. The three SPS funds are exposed to volatility slightly higher than their benchmark indexes. However, the three SPS funds have a semi-deviation lower than or similar to their benchmark indexes. This observation suggests that the three SPS funds are exposed to lower or equal volatility for negative return months. The three SPS funds have positive skewness opposite to their benchmark indexes, meaning they have limited tail risk and higher upside potential. The three SPS funds have kurtosis higher than their benchmark indexes. Higher kurtosis and positive skewness indicate that the SPS funds produce more extreme upside returns than their benchmark indexes.
We evaluate the risk-adjusted performance of the three SPS funds relative to their benchmark indexes with five performance measures: MPPM (Manipulation-Proof Performance Measure), Leland alpha, Stutzer index, Sharpe ratio, and Information ratio. The table shows that the three SPS funds are superior to their benchmark indexes in all five risk-adjusted performance measures. Lhabitant (2000) and Ingersoll et al. (2007) suggest that altering the return distribution of the underlying asset with options would make the performance of the optioned portfolio look better than it is when inadequate performance measures are used. Ingersoll et al. (2007) propose MPPM, which corrects biases of traditional performance measures such as the Sharpe ratio. To address this issue, we calculate MPPM and find that the three SPS funds have a significantly higher MPPM than their benchmark indexes.
We close this section by discussing the intuition for the superiority of the SPS funds. The three SPS funds comprise two sub-portfolios: an index constituent portfolio and a tail risk hedge portfolio. Neither of the two sub-portfolios in isolation has a positive alpha because the S&P 500, Nasdaq100, and S&P Small-Cap 600 are used as a proxy for the market portfolio, and we find that the index option market is efficient. Nonetheless, the three SPS funds generate a statistically significantly positive alpha. No additional investment is required to write SPX calls since an entire fund capital investment in an index constituent portfolio provides margin buying power to cover short positions in index calls. As a result, the option premiums harvested from writing index calls are an extra return in addition to the underlying index return if the assignment/exercise risk is adequately controlled.
Risk and return attributes of Stable S&P 500 Plus, Stable Nasdaq 100 Plus, Stable S&P SmallCap 600 Plus,
and their corresponding benchmark indexes in 1990 (7/2000) – 20221
1. The risk and return statistics for the SPS funds are calculated without adjusting for the performance fee.
2. MPPM is short of the Manipulation-Proof Performance Measure proposed by Ingersoll et al. (2007).
3. The Leland alpha is estimated with the Leland beta, the non-normality counterpart of the CAPM beta developed by Leland (1999).
4. The Stutzer index, created by Stutzer (2000), is the non-normality counterpart of the Sharpe ratio.
*** denotes statistical significance at the 1% level for the Leland alpha based on bootstraped p-values.
** denotes statistical significance at the 5% level for the Leland alpha based on bootstraped p-values.
Tail Risk Hedge
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“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch
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There have been 22 market selloffs/selloffs since 1817, when the NYSE was created, which means that a market selloff occurs every nine years on average in the US stock market. Therefore, market selloffs are indeed a rare event. Most prospective investors of the SPS funds are expected to be in their 50s and 60s with low-risk tolerance. For that cohort of investors, the market selloffs they expect to encounter a few times in the rest of their life could have a lifelong adverse impact on their retirement savings. The reason is that they need more investment time to recuperate the capital loss they would suffer from a market selloff if they maintain a buy-and-hold policy and attempt to ride out the tail event periods. Even the mere possibility of a market selloff might damage their unhedged retirement portfolio since the expectation of a severe capital loss might hinder their rational financial decision-making process. Therefore, for those investors in their 50s and 60s with low tail risk tolerance, tail risk hedging of their retirement assets is essential to their post-retirement financial welfare. The SPS funds offer retail investors the tail risk hedging strategies available only to institutional investors.
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There are two approaches to tail risk hedging: dynamic asset allocation and direct tail risk hedging. Advocates of dynamic asset allocation argue that it is cost-effective. Their argument is based on the premise that direct tail risk hedging generates a trading loss because market selloffs are rare and carry an opportunity cost caused by shifting capital from the return-generating assets to an unprofitable tail risk hedge portfolio. Such a premise does not consider an equity premium that the shift toward a more conservative asset composition would cause to forgo. Furthermore, Leibowitz and Bova (2010) and Bhansali (2010) suggest that a tail risk hedge portfolio provides liquidity to allow investors to exploit the opportunities created by market selloffs.
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Over several years, RISC, the investment manager of the SPS funds, has developed direct tail risk hedging strategies, a core part of the SPS funds. These strategies require the creation of a dedicated self-financing tail risk hedge portfolio. The dedicated tail risk hedge portfolio consists of two sub-portfolios: a permanent, passive hedge portfolio and an actively managed one. The former portfolio is designed to generate an income regularly. At the same time, the latter is constructed to incur a trading loss without market selloffs but yield an outsize trading gain in a tail event.
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The following table shows the performance of Stable S&P 500 Plus, Stable Nasdaq 100 Plus, and Stable Small-Cap 600 PLUS compared with their benchmark indexes in the market selloffs periods of November 2007 through February 2009, January 2020 through March 2020, and January 2022 through December 2022.1) When S&P 500 returned -50.95%, -19.60%, and -18.26%, respectively, during those three periods, the Stable S&P 500 Plus would have made -22.35%, -14.71%, and -17.26% net of the performance fee, respectively. In the same periods, Nasdaq 100 returned -50.11%, -10.53%, and -32.65%, while the Stable Nasdaq 100 Plus would have returned -21.88%, -5.36%, and -31.81% net of the performance fee, respectively. Similarly, when S&P SmallCap 600 lost -50.99%, -32.75%, and -16.00%, the Stable Small-Cap 600 Plus would have returned -22.33%, -28.12%, and 14.96% net of the performance fee. The impressive performance of the SPS funds in the two market selloffs periods, 11/2007 to 2/2009 and 1/2020 to 3/2020, verifies the effectiveness of our tail risk hedging system. The relatively poor performance of the SPS funds in 2022 resulted from no corresponding spike of VIX in reaction to the market selloffs.
The dedicated tail risk hedge portfolio in isolation is designed to make a non-negative return even if a market selloff never breaks out in the future, distinct from most other tail risk hedging strategies. To test if the dedicated tail risk hedge portfolio makes a loss in the absence of market corrections, we partition the monthly returns of the benchmark indexes S&P 500 and Nasdaq 100 in 1990-2022 and those from S&P SmallCap 600 in 7/2000-2022 by the sign of the index return. The table below shows the average monthly performance of the SPS funds in positive and negative return market periods. The SPS funds and their respective benchmark indexes made statistically the same returns in the positive return months. In the upmarket, Stable Plus S&P 500, Stable Plus Nasdaq 100, and Stable Plus Small-Cap 600 yield a mean monthly return net of the performance fee of 3.22%, 5.40%, and 4.22%, respectively, compared with 3.29%, 5.50%, and 4.18% for S&P 500, Nasdaq 100, and S&P SmallCap 600, respectively.
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Drawdowns in the market selloff periods1
1. The 2000-2002 market selloff period is not included in the backtest because of the unavailability of VIX options, a significant instrument in our tail risk hedging system, at that time.
Our dedicated tail risk hedge portfolio is designed to make a non-negative return even if a market crash never breaks out in the future, distinct from most other tail risk hedging strategies. To test if the dedicated tail risk hedge portfolio makes a loss in the absence of market corrections, we partition the monthly returns of the benchmark indexes S&P 500 and Nasdaq 100 in 1990-2022 and those of S&P SmallCap 600 in 7/2000-2022 by the sign of the index return. The table below shows the average monthly performance of the SPS funds in positive and negative return market periods. The SPS funds and their benchmark indexes made statistically the same returns in the positive return months. In the positive return market, Stable S&P 500 Plus, Stable Nasdaq 100 Plus, and Stable Plus Small-Cap 600 Plus yield a mean monthly return of 3.22%, 5.40%, and 4.22% net of the performance fee, respectively, compared with 3.29%, 5.50%, and 4.18% for S&P 500, Nasdaq 100, and S&P SmallCap 600 total return indexes, respectively.
Monthly performance in the positive and negative return markets in 1990-2022 for Stable S&P 500 Plus and Stable Nasdaq 100 Plus, and in 7/2000-2022 for Stable S&P Small Cap 600