I'm not the only one at AQR who gets worked up about silliness in the industry. My partner Dan Villalon takes aim at options-based strategies below—what they claim to be (a free lunch); and what they actually are (a bad deal). Take it away, Dan.

The holy grail for many investors is a strategy that generates market-like returns, but with less risk. Enter options-based strategies, often labeled with words like “Buffered,” “Overlay,” and “Defined Outcome.” 1 1 Close And well-described by the WSJ as “Boomer Candy.”   These strategies use options to capture the upside or downside of an asset’s returns, and managers who employ a mix of options can tailor  an asset’s risk/return profile to align with an investor’s goals. It’s no surprise, then, that Morningstar’s options trading-related categories 2 2 Close Includes all funds in the Equity Hedged (Global Category Options Trading), Derivative Income, and Defined Outcome Morningstar Categories. We use the manager-defined oldest share class for each fund. All returns are net of fees and denominated in USD.   have amassed $234 billion. 3 3 Close Summed across funds active as of February 24, 2025.   

However, investors should expect disappointment from these types of strategies. This is not only because actual results have been overwhelmingly disappointing, but also because economic theory says these strategies should be overwhelmingly disappointing. This note looks at both perspectives. Let’s start with the data.

Have Options-Based Strategies Delivered?

The conventional wisdom—or at least the conventional sales pitch—is these strategies provide an investor with equity market participation, but with less of the downside. That is eminently doable using options. But, of course, the rub is that it doesn’t come for free: in exchange for some of this downside protection, these strategies should be  expected to trail the broad market.

Let’s see how they did.

Of the 624 funds in these options-related Morningstar categories, we look at the 99 that have histories going back to January 2020. For these 99 funds we ask two questions:

1. Did their cumulative returns exceed that of passive US equities (proxied by the S&P 500 Index)? 4 4 Close Note: even though US equities tends to be the most common benchmark, our analysis against global equities yields similar conclusions.
2. Were their worst drawdowns less severe than that of passive US equities? 

The answer to Question 1 is no. Exhibit 1 shows that every one of these funds delivered lower returns than the equity market. For Question 2 we have good news: most (86%) of these funds had smaller drawdowns than the market. Batting 1-for-2 may sound like a reasonable deal to investors, as these strategies often (it should be always!) explicitly state that they give up some upside in exchange for protecting investors’ downside.

But…

…There are simpler ways to get returns that are lower than equities with less risk. For example, instead of putting $100 in the market, an investor could invest only $70 and put the other $30 in Treasury Bills. 5 5 Close It doesn’t have to be cash, of course. Investors might instead choose to allocate to bonds or TIPS or diversifying alternatives (ideally ones that are actually uncorrelated to stocks, so that they don’t add more equity risk).   Presumably, if this simpler approach were more effective than options-based strategies (either via 1. higher returns, 2. less risk, or 3. higher returns with less risk), an investor would prefer it.

The $234-billion-dollar question is whether funds that are marketed as offering downside protection deliver it better than simply having less exposure to equities. Let’s revisit performance through this lens. For each fund, we measure its equity market “beta,” or average exposure to the equity market. 6 6 Close For example, if beta is 0.7, then it means the fund, on average, had 70% exposure to equity market risk.   Exhibit 2 shows the distribution of these betas, showing clearly that one of the ways in which these strategies have delivered less risk is simply by having less exposure to the market.

We now compare each fund’s returns to that of a strategy that simply matches its average equity exposure via a passive index and invests the rest in T-bills. The results are presented in Exhibit 3, which reveals a starkly different conclusion than in Exhibit 1. Now instead of the vast majority of funds underperforming equities but with less risk (i.e., batting 1-for-2), more than two thirds of all funds deliver lower returns with more risk than a simple combination of passive equities and T-Bills (i.e., 0-for-2).

What about risk mitigation? In Exhibit 1, 86% of all funds had smaller drawdowns than the market. But, now that we compare to a more appropriate benchmark, the story is flipped — 81% have worse drawdowns than the simple “passive equity plus cash” combination (bottom row). And, even comparing to this easier benchmark (as holding T-bills should be, and has been, a drag on long-term returns), only 14% beat this watered -down stock market portfolio.

By and large, options-based strategies have not been effective tools to achieve better risk/return outcomes. And this is unlikely some fluke of the past five years. Economic theory would argue investors should have expected this result, and that they should going forward, too. 

Show Me the Theory

At the heart of the strategies examined here are put options. 7 7 Close We believe this applies to most of the funds that pass our filters but we cannot be certain it applies to all.   The way puts work is straightforward: the investor pays some amount (the option premium) to protect themselves from a specific decline in a specific asset’s price over a specific period. 8 8 Close The tedious repetition of “specific” will pay off in a couple paragraphs.   There’s one wrinkle though: when it comes to buying puts, the price of admission is generally higher than the benefit. 9 9 Close See for example Ilmanen (2012), Ilmanen (2013), and Ilmanen et al (2020). If many investors are especially worried about large steep market drawdowns, this will be priced in the market and can cost even more than simple/linear beta reduction.   This is true regardless of whether markets appear riskier than normal or less-risky than normal (i.e., whether the prices of these options are higher or lower than normal). 10 10 Close As shown in Israelov (2015).  

Most options-based fund managers know about this headwind all too well. So rather than simply buying puts over and over, they might sell other options (puts or calls) to generate some income to offset the cost of the puts. There are a bewildering number of put/call combinations managers can create, made even more complicated by the terms used to describe them. 11 11 Close E.g., Straddles, strangles, collars, calendar spreads, diagonal spreads, and butterfly spreads. In credit markets, there’s the “Iron Condor”; we have yet to come across the legendary Iron Butterfly.   Alas, as shown in the first column of Exhibit 3, even these complications don’t make for better or – compared to the right level of equity exposure – even safer returns. 12 12 Close See for example Israelov (2014).

But let’s say an investor is less concerned with long-term returns, and more concerned with shorter-term drawdowns. Surely options-based strategies should at least help there, since a put option is literally tailor-made for this task. 

Nope.

Puts are designed for very specific outcomes – they protect against a specific price level for a specific length of time. If the duration of the drawdown doesn’t align with the maturity of the option, the hoped-for protection won’t be there. 13 13 Close See Israelov (2017).   This is why a strategy that buys 5% out-of-the-money puts every month can have a drawdown that’s worse than 5% – markets might fall by 4% in one month, and by another 4% the next so the options you paid for never pay you. 14 14 Close This 8% drawdown is ignoring addition costs from actually buying the put options in the first place (options are expensive to trade) and the fees charged by the manager for providing (well, claiming to provide) this magical downside protection.   And this is a reason 81% of the funds in Exhibit 3 weren’t able to deliver on the seemingly easy goal of downside protection (again, compared to an applicable mix of equities plus T-bills).

Let’s wrap up this theory section with a practical guide for thinking about options-based strategies: 

1. Options are designed to reshape an asset’s return distribution for a specific period.
2. Over multiple periods, the shape you want is almost certainly not going to be the shape you get. 15 15 Close Both because options are generally expensive and also from the timing of buying them. For example, two managers buying the same put/call combinations, but on different rebalancing schedules can have surprisingly large differences in returns, as shown in Braun et al (2023).
3. You should expect to pay through the nose for it: the cost of trading options, the option premium, and the manager’s fees. 16 16 Close The complexity of these products makes it easy for managers to charge hefty fees for the dubious service of “customizability.”

Investors Have Better Options than Options Strategies

This note has focused on a single comparison: if you’re concerned with equity risk, are you better off a) using options or b) simply reducing your exposure to equities? 17 17 Close This doesn’t have to be by lowering your equity allocation per se; you could also tilt an existing allocation more to “defensive” or higher-quality names, as shown, for example in Asness, Frazzini and Pedersen (2018).   Obviously we believe, based on both theory and realized fact, that option b) is likely to be the better choice. 18 18 Close This is even before taking taxes into account—a topic for another day.  

But investors have more choices than just these two. In fact, we think the best choice might be Option C: diversify better. Any strategy that offers positive risk-adjusted returns that are diversifying to equities is a candidate for improved portfolio outcomes. When looking to address equity risk, we think investors should look past the Morningstar categories covered in this note, and toward some of the other alternatives. 19 19 Close This is about as “salesy” as we’ll get in this note. Oh, and no, illiquidity is not the kind of “other alternative” we mean here.

To be blunt, these “buffered funds” are a marketing success, a success for the managers selling them, and a failure for investors lured in by the overpromise of magical equity returns without equity risk and then overcharged for the pleasure.