Quick Take: It looks like an equity fund, thinks like a hedge fund, and acts like a bond fund. Established in December 1977, Gateway Trust:Gateway Fund (GATEX) calls itself a “risk-adjusted equity mutual fund.” By prospectus, it strives for equity-like results, but a bond-like risk profile.
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?