Patrick Rogers, who has run the fund since November 1994, relies on hedging techniques. "There's no fundamental analysis," he said of the portfolio. "The security selection strictly tries to be efficient in getting market exposure with a similar total return to the S&P 500." The hedging strategy does the rest. Of the fund's 310 holdings as of March 31, 180 issues were equities in the S&P 500; 120 were "non-S&P holdings" -- largely put and call options; and 22 were ADRs. Total assets are about $2.3 billion.
For the three-year period ended March 31, the fund registered an annualized return of 4.1%, versus a gain of 1.8% for the average large-cap blend fund, and 2.7% for the S&P 500. The results were achieved with nearly half as much volatility. For the twelve months ended in March, it rose 6.4%, versus a gain of 5.6% for its peers, and 6.7% for the index. Though Standard & Poor's categorizes the portfolio as a large-cap blend fund, it does not have a stated benchmark.
In September 2004, the fund implemented a change in investment objective and strategy. Rather than purchase every stock in the S&P 500 as it previously had done, it now seeks to own fewer stocks and to approximate the index's price movements while holding a higher proportion of dividend-yielding issues. The portfolio carries a 5-Star rank from Standard & Poor's.
The Full Interview:
S&P: How would you describe your investment philosophy?
ROGERS: We don't select equities based on "buy and hope," or because we think they're going to outperform the market. We select securities to get a representation similar to the S&P 500, with a similar price movement. That supports our options strategy.
Because the S&P 500 is market-cap weighted, the top names dominate movement in the index, and you don't need full replication to get a similar price movement. So, we don't have to own as many names. That holds down transaction costs. It also allows us to be better tax managers. If we were a straight index fund, we would have to make changes in our portfolio when changes are made in the S&P 500.
The option side is where we add value. We use both calls and puts. To use an analogy, let's say that you decide to buy an apartment building in New York and fully lease it out. You're essentially allowing someone to use your asset in exchange for cash flow -- for rent.
It's exactly the same thing we're doing with our option strategy. We have a portfolio of stocks we want to own for a long time. We're hoping for some appreciation, but are mainly interested in using that asset to generate cash flow.
The cash flow comes through the continuous sale of index call options on the S&P 500. We mix up the expirations and pricing of the options to make sure we're getting maximum value. That activity typically brings in about 18%-20% in annualized cash flow. We've seen it as low as 10% annualized, and as high as 40% annualized. We are fully hedging our portfolio.
S&P: Your call options are on the index, but the stocks you hold represent what's in the index.
ROGERS: That's why it's important that the stocks we have in the portfolio move in a similar manner to the S&P 500, so that we have a nice match with the index option side, so that they will move in relation to one another.
Let's say Microsoft (MSFT) is at $25, and I sell a Microsoft call option to you that expires in June and has a strike price of $25, for a $5 premium. Obviously, if Microsoft stays where it is or goes down, you're not going to make any money, and I get to keep all of that premium. The break-even would obviously be $30. So you're trying to turn a $5 investment into unlimited upside. What I'm doing is giving up whatever upside potential I could make from Microsoft in exchange for cash flow.
Index options are totally different from individual options -- they only settle in cash. There's a continuous market, and we know on a minute-by-minute basis what each option is worth.
The important distinction for us is that we're never exposing any of the stocks in our portfolio to being called away. That minimizes some bad potential tax ramifications.
S&P: You might in some cases have to fork over some cash.
ROGERS: Correct. And if we don't have enough cash in the fund, we may have to turn to those stocks and sell some of our shares to meet that liability.
S&P: Does that happen very often?
ROGERS: No, because the market would have to rise pretty dramatically. One of the beauties of our strategy is that when we need to raise cash, it is at a time when the market has done extremely well. So essentially, it forces us to sell securities after a big run-up.
Let's say Microsoft goes down to $20. I still own Microsoft and feel that move, but am able to keep your $5 premium. I'm now sitting with excess cash, so it forces me to buy stocks after the market has fallen. We're fully invested. So it's a nice little discipline imposed in the strategy.
The index itself isn't going to be as volatile as one of its components would be. We think it's well worth the reduction in that volatility in order to have the great benefits from index options.
S&P: Who buys your call options?
ROGERS: Individual investors who are speculating; hedge funds who are using options to offset some of their risk; and institutional investors and dealers on Wall Street trying to offset the risk on their own books.
The other thing we love about index options is they're far more liquid than individual stock options. In fact, the S&P 500 option is the most actively traded option in the world.
The last component of our strategy is puts. As someone who owns the security and sells the call option, we have full exposure to downside risk, minus whatever we sold that call option for.
We don't like to expose the portfolio to all that pain, because our fund is very conservative. We're trying to earn rates of return normally found in other conservative asset classes like fixed income. So we use some of the cash flow to buy downside protection in the form of index put options. A put option gives you the right to sell your securities at a certain price over a certain period of time. So it's like owning an insurance policy with a deductible.
We're not so concerned about a moderate decline in the market, because we've got cash flow coming in to offset that. What we're concerned about is a major decline in the market in a short period of time. The put options that we buy are between 8% to 10% below the market, so we are essentially buying insurance policies with an 8% to 10% deductible...
S&P: ...that limits your loss to that amount.
ROGERS: Exactly. And the cost is a lot cheaper than if you were to try to protect every single dollar decline in your assets.
So, when you wrap all this together, you're left with a potential performance profile that is pretty limited. We're certainly not going to hit any home runs if the market's doing well, because we've sold off that upside. The most that we can earn is essentially the net cash flow, the net premium, from selling the index calls versus what we're paying for the downside protection. That typically has been about 12% per year.
We've seen it as low on a net basis as 5%-6% about 10 years ago. Last year, like this year, that premium is lower than normal, so we're looking at returns of 7% or 8%. But we've also seen it as high as 20%, right after the crash of 1987, in 1988-89.
S&P: Does the movement of your fund follow the bond bull market?
ROGERS: No, and that's why it's such a great asset allocation diversifier. Our raw volatility is going to be similar to what you would find in an intermediate- to longer-term fixed income fund. But there is no correlation to fixed income. As a matter of fact, we like higher interest rates because they're one of the pricing components in options.
When the bond market is doing very well, we are going to have our substandard quarters. And when the bond market has typically done poorly is when we have done well.
A lot of professional investors in institutional accounts place money with us as an alternative to fixed income. We have a great diversified ability away from fixed income, even though our risk is similar from a volatility standpoint.
Contact Bob Keane with questions or comments at: firstname.lastname@example.org.