How Exchange Fund Replication (EFR) Brings the Power of Options to Investors

September 30, 2022

Guest Author: Eric Metz, President and Chief Investment Officer, SpiderRock Advisors

Exchange Fund Replication (EFR) is a strategy designed to achieve the diversification and capital-gains tax deferral of exchange funds—not to be confused with exchange traded funds (ETFs) —while also providing greater liquidity, transparency, flexibility and tax efficiency.

EFR allows investors to diversify their concentrated stock positions by applying option strategies within a separately managed account (SMA). Although some investors, and even advisors, may automatically equate option strategies with risk and speculation, option strategies are more often used to precisely hedge and manage risk and taxes. For example, collar option strategies on individual securities are a tried-and-true method for managing portfolio risk, especially and more importantly, idiosyncratic risk.

With EFR, investors can exchange their single-stock risk for market risk while preserving daily liquidity, full transparency and the ability to reduce the stock position in a tax-neutral manner over time—all at a lower cost than the typical exchange fund. The strategy is implemented through an SMA, which gives advisors more control and transparency within their clients’ accounts. EFR also helps advisors scale to work with more high-net-worth clients and spend more time on wealth management, a key value-add for clients with concentrated stock.

Investors and their advisors have been using exchange funds for decades to diversify low-basis concentrated equity positions. But this technique has several important limitations. EFR, which applies option overlays to an SMA, improves on many of the drawbacks of traditional exchange funds. 

Figure 1: Exchange Funds vs. Exchange Fund Replication

Source: SpiderRock Advisors

How Exchange Fund Replication Works

Each customized overlay in an SMA begins with identifying the client’s goals, including how much of the concentrated stock should be hedged. Other key decisions include establishing how much diversified market exposure the client requires and which market cap and sector exposures the client needs. Virtually any index or ETF with liquid options contracts can be used. Next, there are two primary option-based components of implementing the strategy:

1. Hedge the concentrated stock position: A collar option overlay is implemented by purchasing put options on the stock, while at the same time selling call options. Owning the put options hedges downside risk, and the proceeds from selling the call options provide funding to pay for the put options. The resulting single-stock position is collared and often premium neutral.

2. Create diversified market exposure: Once the collar is created for the concentrated stock position, an offsetting position is created in any equity or bond index by selling put options and using the premiums to finance the purchase of call options on the index. The resulting combination is long a collar on the concentrated stock, and short a collar on the index. This is sometimes called a risk reversal or squash strategy. As a result, concentrated equity exposure is transitioned to market equity exposure, and the premium is often neutral as clients desire a cashless position.

The chart below shows an example of the potential exposures that could be created using EFR to swap a concentrated stock exposure for S&P 500 exposure. The investor has exposure to the concentrated stock within the bounds of the collar and exposure to the S&P 500 above and below those bounds.

Figure 2: Exchange Fund Replication at Work

Source: SpiderRock Advisors

Options 101: Skew—Why Options May Deliver Better Risk-adjusted Returns than Exchange Funds

In addition to providing enhanced liquidity, transparency and flexibility, EFR has the potential to deliver superior risk-adjusted returns compared to a traditional exchange fund. This potential is driven primarily by a concept called skew, which describes the relationship between out-of-the-money calls and puts on a given security or index.

Skew can be measured by the slope of an implied volatility curve across option strike prices. In general, the protective puts on an index are more expensive than equidistant bullish call options on the same index. Puts on broad indices are more expensive because an index tends to rise slowly and sell off fast. As the saying goes, “markets tend to take the stairs up and the elevator down.” This asymmetric relationship benefits an EFR strategy that sells the (more expensive) index puts and purchases the (cheaper) call options.

The relationship of option prices on individual stocks is more neutral—and in some cases out-of-the-money calls can be more expensive than the equidistant puts. This is often because single securities tend to be more volatile but, more importantly, have a higher probability of asymmetric moves than an index. Option markets reflect these dynamics, which can be quantified and analyzed through the lens of skew. Implementing EFR can help investors leverage this tendency because the strategy sells (more expensive) call options on the concentrated stock and buys the (cheaper) put options.

Putting it all together, the skew relationship between option prices for individual stocks and indices creates the potential for investors to get “paid” via the net premiums for accomplishing their overriding goal: transferring risk from a single stock into diversified equities. This dynamic may also contribute to favorable upside/downside capture ratios.

Strategic Liquidation and the Potential for Tax Alpha

Finally, tax efficiency is another very powerful benefit of EFR. In a traditional exchange fund, at the end of the lockup period, investors receive a diversified basket of securities in exchange for the concentrated stock they contributed years earlier. The investor will have been forced to accept tracking errors to broad-based indices that may vary widely depending upon the other Limited Partner’s contributions into the fund. Investors have no control over what this basket may look like—or the cost basis of those securities. In short, investors may have diversified their exposure and delayed paying capital-gains taxes, but they still have a tax equation to solve to get any desired liquidity.

In contrast, EFR may do more than simply delay capital-gains recognition; it can help investors reduce their overall tax exposure by strategically liquidating the concentrated stock over time.

Strategic liquidation involves taking opportunistic mark-to-market or realized losses on any of the four option positions in EFR in any tax year. The investor can book a realized loss on the option and use those losses to offset gains on sales of concentrated stock. Over time, strategic liquidation can improve the basis on the concentrated stock and reduce the embedded capital-gains liability.

Bringing the Power of Options to Investors

EFR is a combination of basic and well-known option strategies. They can be powerful tools for achieving tax-efficient diversification, transparency and daily liquidity when combined strategically in an SMA.

However, it is important to realize that maximizing the potential benefits of EFR isn’t a “set-it-and-forget-it” proposition. One of the biggest benefits of EFR is the flexibility to adjust the exposures over time to align with any changes to the investor’s objectives, as well as the investor’s views on broader market conditions and the underlying stock. Furthermore, opportunities for tax-loss harvesting and associated strategic liquidation need to be monitored, and the options need to be managed and renewed to align with the underlying positions.

This article is part of Cboe’s Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email [email protected] or contact your Cboe representative to learn more.

There are important risks associated with transacting in any of the Cboe Company products or any of the digital assets discussed here. Before engaging in any transactions in those products or digital assets, it is important for market participants to carefully review the disclosures and disclaimers contained at: https://www.cboe.com/us_disclaimers/. The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Global Markets, Inc. or any of its affiliates.