Do Options-Based Strategies Capture Market Gains Without The Risk? (EP.199)

0:28We all need to make smart decisions with our money. like upside, but with a little cushion on the downside. Well, that's exactly what many options based strategies are promising. Packaged up with labels like buffered, defined outcome and overlay. They sound smart. They sound safe. They sound like the holy grail for investors who want growth without the gut punches. But here's the reality. That promise hasn't panned out. And speaking of promises that don't always deliver, when was the last time you stepped back to evaluate your full financial plan? If you want to see what you might be overlooking, I've created a simple tool to help.

1:08In just 15 questions, my financial assessment will highlight key opportunities and gaps in your plan, and you can take it now at smartmoneyquiz.com or click on the link in the episode description of your podcast app. Today, we're going to take a closer look at options-based strategies, why they're popular, what they actually do, and whether they're worth the cost. I'll walk you through some of the surprising research, including insights from a recent AQR paper that pulls back the curtain on these strategies. This is The Long-Term Investor, and let's dive in. We're going to start with the basics.

1:45What exactly are options-based strategies? If you've come across terms like buffered ETFs, defined outcome strategies, or equity overlays, you're looking at strategies that use options or financial contracts that reshape how returns show up in your portfolio. Here's how the pitch usually goes. These strategies aim to give you some of the market's upside while limiting how much of the downside you experience. That sounds like a reasonable trade-off at the surface, right? And according to Morningstar, there have been over$230 billion invested in options-related categories. So clearly a lot of investors are buying into this idea.

2:26But the key question is, do these strategies actually deliver on that promise? A recent paper by AQR, which I will link to in the show notes at thelongterminvestor.com, takes a hard look at these products and what they found was, well, disappointing. They analyzed 99 funds with at least five years of history. So we're talking about real data here, not just back tests. And they look to answer two simple questions. One, did these funds outperform the S &P 500 over that period? And two, did they deliver smaller drawdowns, meaning did they limit losses better than the market? The results? Zero of the 99 funds beat the market in terms of cumulative returns.

3:11And while 86 % had smaller drawdowns, that's only part of the story. At first glance, you might think, well, okay, I'll give up some return in exchange for less risk. That sounds like a fair deal, but then AQR asked a better question. What if you just owned fewer stocks and held the rest in cash? In other words, instead of putting$100 into the market, what if you put$70 into a simple S &P 500 index fund and$30 into treasury bills? No fancy derivatives, no complex fund structure, just a basic low-cost allocation. And guess what? More than two-thirds of the option-based funds underperformed that simple mix, not just in returns, but in risk as well.

3:57In fact, 81 % of those funds had worse drawdowns than a passive equity in cash combo. Let me say it again. Most of these strategies failed to protect on the downside and they didn't deliver on the upside. So they went 0 for 2 on the simple objectives stated by and evaluated by AQR. So why does this happen? At the heart of many options-based strategy is the humble put option. A put gives you the right to sell a stock at a certain price, offering protection if the market falls. And that sounds perfect. You're essentially buying insurance against losses. But like any insurance, it's not free. In fact, it's usually expensive.

4:39Academic research shows that put options tend to be overpriced relative to the actual protection they provide. In other words, you're often paying more for the protection than it ends up being worth, especially over time. And that's just the beginning. Because options expire, they're only useful for a specific period. So let's say you buy a put that protects you for one month. If the market drops 4 % in one month and then another 4 % in month two, your put may actually expire worthless after the first drop. so you end up losing money without getting the protection you paid for. Even worse, to offset the high cost of these puts, many fund managers layer in other options, selling calls, using exotic combinations, creating a defined outcome that looks nice in a sales deck, but those layers add complexity and often just dilute returns further.

5:35Consider this analogy. imagine you're buying an umbrella that only works when it rains exactly 1.25 inches between 2 p.m. and 4 p.m. If it rains outside that window or if it rains harder, you still get wet. And oh, by the way, you paid a premium for this, quote, smart umbrella. Now, to be clear, this doesn't mean that all use of options is bad. In the right hands with the right goals, they can be useful tools, especially for institutionals managing very specific risks. But for individual investors who don't have an advisor or even most advisors, these products often sound better than they are.

6:15They're marketed as some kind of a magic solution. Equity returns without equity risk, but in reality, they've mostly delivered lower returns with more risk. And that's before factoring in the cost of trading, of the options premiums, of the management fees, of the taxes from frequent rebalancing, and all these things eat away at those supposed benefits. So what's a better approach? Well, AQR suggests something simple, and I agree. If you are concerned about equity risk, just own fewer equities. Dial down your stock allocation. Hold more high-quality bonds or short-term cash-like instruments. You don't need complex financial engineering to reduce risk.

7:00Simplicity often outperforms, especially over time. But there's also what I think of as an option C, one that might even be better, and that is just to diversify smarter. Rather than trying to time the market or buy temporary protection, focus on building a portfolio of return streams that aren't perfectly correlated. Think global stocks, bonds, and maybe even alternatives in some limited cases, and spread your risks thoughtfully, not reactively. When you diversify well and keep costs low, your portfolio becomes naturally more resilient. You don't need to buy an expensive safety net. You build one into the structure of your plan.

7:43Before I wrap up, let me leave you with this. If a strategy promises you equity-like returns with less risk, you should pause and ask, how exactly is this being achieved? If the answer involves complex derivatives, multiple layers of fees, and assumptions that require perfect timing, proceed with caution. Because as we've seen with these options-based strategies, the only guaranteed winners are often the fund managers, not the investors. Thanks for listening to The Long-Term Investor. If you enjoyed this episode, make sure to check out past episodes where we dig into portfolio design, investor behavior, and long-term strategy.

8:24And if you've ever been pitched one of these defined outcome notes, and if you've ever had a question that you hope I address on the show, go over to thelongterminvestor.com, sign up for my email and shoot me a note. I would love to hear from you. I respond to everybody. Until next time to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

9:07This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.