It’s Good to Have Options, Part 4: Optimal Allocations

In the previous articles in this series, I provided an overview of registered index-linked annuities, or RILAs (Part 1); discussed different implementation vehicles and approaches (Part 2); and contrasted buffer and floor strategies (Part 3). In this piece, I’ll use a utility-based resampled optimization framework to show how allocating to options-based strategies can improve the efficiency of a portfolio.

Floor and buffer strategies can improve portfolio efficiency, but the allocations to them depend on a host of factors, such as strategy attributes, investment circumstances, key assumptions, etc. Buffer strategies appear to be relatively more attractive than floors, although floors with no downside risk (i.e., a FIA) are attractive in certain scenarios.

Overall, this series demonstrates that options-based products are worth considering alongside other, more traditional investments in client portfolios.

Allocating to buffer and floor strategies

Options-based strategies aren’t a new asset class, but rather a derivative of an existing asset class. For example, if the underlier is the S&P 500, the return of the strategy is going to be based entirely on the price return of that index. While the options-based strategy could reshape the return distribution – potentially significantly – the underlier drives the return. To improve the efficiency of a portfolio, such a product (or strategy) would need to reshape the return distribution in such a way that was more attractive given the additional potential costs.

A variety of risk metrics can be used within a portfolio optimization framework. Variance (and standard deviation) is one of the most widely used definitions of risk but is poorly suited for analyzing an approach with a non-normal return distribution. While other risk metrics such as value at risk (VaR) or conditional value at risk (c-VAR) can more directly consider downside risks, they generally focus only on part of the entire return distribution and are unlikely to capture the unique risks associated with an approach that employs options.