Practical Applications of Risk and Return of Equity Index Collar Strategies

Abstract

At first glance, equity index collars can look like an attractive way to hedge against risk, because of their purportedly zero-cost implementation. But you end up paying for the collar in other ways that make it a less than optimal strategy.

Authors Roni Israelov and Matthew Klein, both of AQR , take a closer look at the collar’s portfolio impact, and they find that a typical collar provides lower returns and a lower Sharpe ratio than the S&P 500 Index, primarily because it earns a lower equity risk premium. They also compare the collar strategy to some alternative solutions. “If investors must maintain their portfolio’s return target, then alternatives can replace the lost equity risk premium with alpha,” the authors suggest.