Equity Income Ingenuity

What do clients near, or in, retirement say when advisors counsel them about how much they can prudently take out of their portfolio each year if they want to ensure that it can last for their lifetime? The 4% to 5% figure heard so frequently may elicit a groan, and might not be adequate for some clients; if you agree with the thesis that people will be living much longer lives and therefore sustainable income may be required over that longer lifetime, it may be time to consider other options. Would some clients be willing to trade some upside relative to the S&P 500 for higher income, lower volatility, and lower downside risk?

There is a fund that starts with dividend-paying equities, and systematically writes call options on a portion of that portfolio, receiving added income in the form of option premiums. This technique has another effect: it tends to make the equity portfolio less volatile, more conservative. The fund is managed to be tax-efficient, so it can be held in personal accounts outside of qualified retirement accounts. All this adds up to a strategy that could make a difference to “someone who is moving into retirement and is looking for a nice source of after-tax cash-flow coming from their equity holdings,” says Donald J. Mulvihill, managing director at Goldman Sachs Asset Management and senior portfolio manager of the Goldman Sachs U.S. Equity Dividend and Premium Fund (GSPAX).

Typically we spotlight funds that have at least a three-year track record, but because this younger fund’s strategy is unique, and income is such a critical issue for many advisors’ clients, IA has made an exception. The fund’s inception date was August 31, 2005, and according to Standard & Poor’s the fund had a total return of up 8.11% versus 9.14% for its benchmark, the S&P 500 Index, and assets of $153.4 million (A shares), through August 31, 2006. The fund is too young to have an S&P star ranking.

How much money is in the fund now?

Today we have about $190 million, it’s growing very steadily, flows are coming in all the time, there’s no Goldman seed money in there, that’s all client money.

With this fund are there also private accounts and other associated portfolios?

There are some private accounts but we’re encouraging people to use the fund because we think the fund is a good vehicle for participating.

What makes this fund different from a typical U.S. dividend funds?

First of all we think that it’s a useful tool to put in the toolbox of an advisor because it allows them to develop a more customized solution for a particular type of investor. I think that’s important; a lot of the mutual fund industry’s funds are managed by people who, for the most part, manage pension assets, so they’re not always sensitive to tax issues, and the whole idea of the categorization of funds into all equity and the further categorization into small-cap and mid-cap, and growth and value, a lot of that logic comes from the tax-exempt world. We, not just with this fund but with other things we’re doing here, are trying to think more about the fact that individual investors have different needs and they are not the same as pension funds’ [needs] and so we should be designing products that meet specific needs and therefore you could think of it as a useful toolbox. We want to help give investment advisors and other brokers who use our funds the tools they need to do a good job for their clients.

The particular type of investor we’re thinking about is someone who is moving into retirement and is looking for a nice source of after-tax cash-flow coming from their equity holdings. This is an increasingly common issue–this issue of longevity risk. When people retired with pension plans, longevity risk was shared within the plan. Some people died when they were 66, some people lived to be 96, but everyone got a check as long as they lived, and that risk was calculated by the actuaries to the plan, and that’s how they figured out how much they could pay out. If you retire with a defined contribution plan, you are not in a pool with anyone else, you’re on your own, and so this question of “Will I outlive my money?” is a much more pressing issue, and people do live a long time. The life expectancy if you think in terms of, let’s say, the second-to-die of a couple in their early 60s–that could be 30 years.

The conventional wisdom–that as you move into retirement you’re supposed to start owning a lot more bonds–I’m not sure that’s good advice for someone who is looking to preserve their spending power over a period that could be several decades. Inflation is the enemy of a bond investor, of any investor, but the after-tax return on bonds is about equal to the rate of inflation, historically. If your goal is to generate both spending and a return that keeps up with inflation, so that you don’t go into that death spiral of consuming increasing amounts of your wealth, it’s not clear that bonds serve that goal, whereas equities, while they may be riskier, are more likely to give you a return above the rate of inflation and therefore allow for some spending. We were thinking about how we could provide an equity-oriented product for investors in this space, and further we said many of these people will like to get regular cash-flow, and they might be willing to give up some of their upside in exchange for some ongoing stream of cash, more so than you or I who are still working and saving money might be. That led us to think about options as a way to effect that–to give up some of the upside in exchange for additional cash. Further, we thought about how to make this tax-efficient.

To be a little more precise about how people might use this fund, many people have both a retirement account and personal assets. You’ve heard about asset location–which of my investments go inside a retirement account, and which go outside. If you could own something like this in your personal account, and it is tax-efficient, throwing off qualified dividends, and long-term gains which are taxed at 15% or whatever the long-term rate is, then, that actually will do better than if you put it in your retirement account, where it may be deferred, but it will ultimately be taxed at 35%. Therefore to the extent that you want to have some allocation to bonds, you can put it inside the retirement account, and there the after-tax return on bonds is a lot more attractive than it is in your personal account. I’m being increasingly specific about how people might want to use this, but that is a great use of this particular tool: in the personal account of a taxable investor, who wants to be in the equity market but would like to get a nice after-tax cash-flow from that equity investment.

Would you talk about your investment process and the mechanics of the fund–how the dividends and the options premiums work?

First, about the stock portfolio: the fund remains fully invested at all times, we are broadly diversified relative to the S&P 500, we require that industry weights and sector weights be very similar to the benchmark, and so you might think of this stock portfolio as being kind of quasi-indexed, except for the fact that we have a bias towards the higher dividend-paying names within each industry. We do not alter the industry weights. In other words, if you really wanted a high dividend yield you would concentrate in tobacco, and utilities, and banks, but that would raise sector bets. We constrain the portfolio not to deviate from the benchmark in terms of sector weights, so we’re really favoring the higher [dividend] payers within each industry as opposed to favoring the higher payers across the whole market, and that gives us a gross dividend yield of about 3.25%. That’s the stock portfolio; it’s not actively managed, there’s a fair number of names and it’s a form of indexing, you might say. ‘Dividend biased indexing’ might be a good term to use. Think about a balance sheet so that’s the asset side of the balance sheet.

On the liability side we have our index options and when we write index call options we tend to write them between one- to three-months maturity at, or slightly above, the market. When we write an option we immediately get a payment of cash; we now have a liability, because if the option expires in the money we need to make a cash payment at expiration. Now, if the market goes up the value of our assets should go up because the stock portfolio is worth more, at the same time the value of the liability–the call option that we’ve written–also goes up, and vice versa, so the presence of index options tends to dampen the volatility of this portfolio–it’s not as volatile as the stock market itself. We tend to write options against about one-third of the notional value of the portfolio, so if there were $100 in the fund we would have index options written against about $33 worth of stock.

Over the year we ran the fund, the realized volatility was only about 83% of the volatility of the market. To understand why, think about that: if we just had the asset and it’s kind of indexed to the market you would expect this volatility to be about equal to the market, but we’ve got this liability that moves with the market as well, so if the market goes up 1%, the value of our assets might go up 1% but the value of our liability might rise by one-third of 1%. That tends to dampen the volatility, which goes back to the point that this is a more conservative way of being in the equity market.

Both from the call options premium aspect and the dividend aspect?

Well, the dividend just kind of changes your return–you get more of your return as a dividend as opposed to appreciation. One question that sometimes comes up: Do we have a value bias because of the fact that we favor higher dividend payers? The answer is no, there is little or no value bias because of the fact that we constrain the sector weights. In other words if you were to compare the Russell 1000 Value to the Russell 1000 Growth, their sector weights are enormously different. In this portfolio, even though we’re favoring dividends, we still require that our sector weights resemble the S&P 500; we are neither growth nor value, we’re pretty much a blend. The presence of the index options is a form of hedging, and therefore it dampens volatility, which is why I think it’s a more conservative way of being in the market.

Can you walk me through how it dampens the volatility?

That balance sheet is the example I usually try to use. The balance sheet was $100 worth of stock, and on the liability side index options against $33 worth of stock. The market moves 1% up, so our assets [the stock] are now worth about $101, and the liabilities are worth about $33.3, so the NAV rather than moving 1%, which is what the market did, would move about .67% and vice versa.

Have there been any surprises this first year?

No, it’s pretty much worked the way we expected it to, now it hasn’t been a terribly surprising market either, but it’s a broadly diversified portfolio so the returns of the stock portfolio are similar to the returns of the benchmark. The dividends–we’ve hit our target of about 3.25% gross dividend, and, because of the way we managed the portfolio we’ve been able to distribute almost all of the gross dividend to the investors, and that is nice because people come to this looking for income. We have not distributed any short-term gains, you know we were only open for a few months last year, and we don’t expect to distribute any short-term gains this year either, but we will distribute some long-term gains.

One thing that I should probably explain and make very clear: the return we get from options consists of the premium received, less any cash payments made at exercise, and that’s actually marked-to-market each year. That net number is treated as being 40% short-term/60% long-term, which is an advantage versus your traditional single-stock options where you can generate a lot more short-term gain, but it is capital in nature, it is not income, therefore it cannot be included in the quarterly distribution of dividends, but rather it ends up as a part of the annual distribution of capital gains. We manage the stock portfolio with a bias towards realizing some short-term losses and long-term gains in order to try and sterilize any of the option program that ends up generating short-term gains. Our goal is to have what’s distributed out to the investor consist of qualifying dividends and long-term capital gains, which is why we think it’s a good source of after-tax cash-flow.

This fund sort of straddles the actively and passively managed portfolios because even though you’re kind of matching the index it’s not all matching the index?

Right, so the activity is, first of all, the dividend biasing, and we are sensitive to when there are record dates so we have a program in place to try and forecast record dates and dividend payments out for at least the next 61 days, because there’s a requirement that you hold a stock for 61 days for the dividend to qualify for long-term tax treatment.

As we are rebalancing the portfolio or investing new flows into the fund, not only are we looking at the annualized dividend yield of stocks, but we’re also looking at those stocks that are going to have a record date coming up in the next 61 days to try and grab additional dividend return that way, so that’s an element of activity [that is] not activity you think of in terms of a traditional stock picker, but neither is it indexing.