Since lows set during the pandemic, the S&P 500 Index has compounded at 25% per year. With the exception of 2022, drawdowns have tended to be shallow and manageable. Put another way, most investors have been penalized for making any change to their asset allocation. But what if markets were to take a pause from the all-time highs set on July 16? In our view, the WisdomTree PutWrite Strategy Fund (PUTW) could be the ideal strategy for flat-to-down markets.

What’s under the Hood?

The Fund sells put options on the S&P 500 in order to generate premiums of 2.5% per month. Should the market stay flat over the next year, it would be possible to generate returns of 30% (2.5% x 12 months). In exchange for the premiums, an investor sacrifices some upside potential should the market rally, and they could also experience losses should the market sell off. However, due to the Fund’s mechanics, you would expect to outperform the market by 2.5% per month on the downside.

Examining PUTW at Previous Market Highs

While the following analysis has the benefit of hindsight in knowing that the market did not continue higher over the period, put writing gives investors the opportunity to limit their beta exposure to the market, in effect reducing drawdowns while still maintaining some correlation to the market should markets potentially churn higher. Should the frequency (or magnitude) of drawdowns increase, investors benefit by collecting higher extrinsic value from the options’ positions.

Figure 1: Cumulative Total Return: 7/16/24–Present

Since July 16 of this year, markets have generally trended lower, with the sell-off accelerating in early August when U.S. labor markets started to show signs of cooling. While markets have rebounded from the lows, PUTW has maintained the return advantage it experienced during the sell-off.

Figure 2: 7/28/23–11/24/23

Entering Q3 2023, there was also concern that market fundamentals might have started to show signs of age after a rapid increase in prices in 2023. While volatility was comparatively low entering this period, the fact that PUTW targets a 2.5% premium meant that the strategy really started to shine versus the S&P 500 Index as markets trended lower. While we know that markets ultimately recovered, PUTW outperformed by nearly 300 basis points to the lows, helping investors remain invested. After touching the lows at the end of October, the AI trade appeared to be back on as markets quickly rallied to all-time highs. While performance eventually eclipsed the returns of PUTW for this period, there was no guarantee that markets would not continue to be volatile.

Figure 3: 12/29/21–12/12/23

In what ended up being an extremely challenging year for U.S. equities, 2022 presents a textbook case for PUTW in action. During this time, traditional hedges like fixed income failed to offset losses in equity markets. During the initial downdraft, PUTW outperformed the S&P 500 Index by approximately 10%. Since markets remained volatile, PUTW was able to compound this advantage throughout the year, ultimately outperforming to the upside even as markets ground higher into 2023, albeit with lower volatility.

Sources of Return

In the case of equities, it’s pretty straightforward—changes in prices plus dividends equal total returns. For PUTW, investor capital is invested in U.S. Treasury bills, which accrue interest linked to U.S. short-term interest rates. Additionally, the strategy targets a 2.5% premium from selling put options. When volatility is high, investors can benefit by selling options that are closer to at the money. During periods of lower volatility, PUTW sells options that are slightly in the money to achieve its income objective.

Conclusion

While equities have delivered strong returns recently, there is no guarantee that the Goldilocks period of high returns and historically low volatility will continue. In our view, a strategy like PUTW could add significant value to investor portfolios should markets remain volatile and/or rangebound.