Barron’s had an article over the weekend titled Why An Options Fund Is A Good Idea Now. There may have been a couple of different catalysts for the article including the recent creation of a category for these funds by Morningstar as well as the sentiment expressed by the author about bond yields being very low. The article then goes on to describe the different types of options funds in the category.

I’ve been writing about options funds for many years and believe in them in proper moderation and with the proper expectations.

First thing is that I think moving assets earmarked for fixed income into equities, even low volatility equities with high yields is something destined to end badly. I’ve made this point countless times before, equities with low volatility still have a lot more volatility than most bond funds and individual bonds. An equity that goes down 25% in a down 50% world is a good relative result…. for equities, but not so for the typical fixed income portfolio. I think many of individual investors doing this are overestimating their tolerance for volatility and advisors doing this will be having some painful conversations with clients.

Options funds are typically equity portfolios with some sort of options overlay that attempts to smooth out the ride when compared to a broad based equity portfolio, not a fixed income portfolio. Some of them will also add a little yield to the portfolio.

The next time the equity market goes down a lot, options funds being lower vol equity proxies, will also go down a lot. Hopefully though, they will go down much less than the broad market. Invariably there will be a couple of the category that do manage to come through the next bear market without going down that much and that would be great but would probably involve a whole lot of luck.

To be clear, I do think down 25% in a down 50% world (for investors as opposed to traders) is a very good result and I do think that is a more reasonable expectation/hope for an options fund than being flat or down just a little bit as equities cut in half.

The context of these posts about how to avoid the full brunt of large declines is not how to be flat or up in a bear market, but how to avoid a large chunk of that decline, how to hopefully go down less. As a reminder, the average annual return of the equity market includes all the huge up years and massive declines all of which averages out to 7%, or 9% or whatever depending on the time period you look at.

Someone lucky enough to go down 25% in a down 50% world for even just one bear market on their lifetime, and who then just stays relatively close to the market the rest of the time have a very good chance at having the long term portfolio result they want (assumes an adequate savings rate).

As a postscript I would add that other portfolio tools that could help reduce the full impact of a large equity market decline include gold, funds that one way or another sell short, absolute return, market neutral and a fund that will one way or another shift away from equities as part of its strategy. While this general approach worked during the financial crisis, there can be no guarantee that it will work the next time.