Dan Villalon, Global Co-Head of Portfolio Solutions at AQR Capital Management, dives into the complexities of option-based strategies in risk management. He reveals that while many funds aim to provide downside protection, most actually underperform benchmarks. Dan discusses the unique challenges faced during market turbulence like the COVID-19 crash and the inflation-driven downturn in 2022. He also critiques buffered funds, exploring their trade-offs and misconceptions surrounding their effectiveness. Tune in for insights into navigating the intricate world of ETFs and mutual funds.
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insights INSIGHT
Option-Based Funds Often Underperform
Most option-based risk-managed equity funds underperform their beta-adjusted benchmarks in both returns and drawdowns.
Even downside protection strategies failed to protect well during significant market crashes.
question_answer ANECDOTE
Research Initiated by Colleague Request
Dan Villalon began this research after a colleague requested insight on options-enhanced equity funds.
The study covered a broad set, including buffered, income, and options trading funds.
insights INSIGHT
Systematic Nature of Option Strategies
The studied option-based strategies are highly systematic with little discretion, often making one trade a year.
This mechanistic approach appeals to investors seeking clear, rule-based protection.
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Today’s world of ETFs and mutual funds increasingly features new flavors, a popular one of which is derived from embedding optionality. There are plenty of ways in which one might contemplate risk managing and shaping the distribution of equity returns using options. Common strategies like overwriting create income, but limit upside. Others like the zero cost collars create both upside and downside guardrails on returns. These strategies can be back-tested. Because they also exist in the market, with more than $200bln in AuM, the performance of the funds can be evaluated as well. With this in mind, it was a pleasure to welcome Dan Villalon, Global Co-Head of Portfolio Solutions at AQR Capital Management, back to the Alpha Exchange.
Dan walks us through the findings from his research, published in a two-part series on the AQR website. In these notes, Dan dissects the drawdowns and returns across these funds. The findings are rather striking: across a wide sample of buffered funds and option-based strategies, very few delivered both higher returns and smaller drawdowns. In fact, most underperformed their beta-adjusted benchmarks on both fronts—meaning they not only lagged in returns but also failed to meaningfully protect against losses in periods like the COVID crash, the 2022 inflation-driven drawdown, and the volatility of early 2025. Even strategies designed explicitly for downside protection often fell short when it mattered most. I am a big believer in option strategies and in the value of the SPX options market as a vehicle to transfer risk. These results were a surprise to me.
Dan outlines three key drivers: the persistent cost of buying options, the structural frictions involved in implementation, and the surprisingly high management fees for such rules-based products. Dan also introduces a more behavioral theory—what he calls the "placebo effect": the idea that investors feel safer simply because they're told they’re protected, even when the data shows otherwise.
I hope you enjoy this episode of the Alpha Exchange, my conversation with Dan Villalon.
Alpha Exchange