Building durable portfolios in a volatile market with active management and risk reduction strategies was the conversation among portfolio managers at the 4th annual Natixis Investment outlook luncheon yesterday.
The luncheon at Per Se in Manhattan's Time Warner Center featured Loomis Sayles Absolute Strategies Fund manager Matthew J. Eagan, Gateway Fund manager Michael T. Buckius and Hansberger Emerging Latin America Fund manager Francisco Alzuru.
Moderated by Natixis Global Asset Management Senior Vice President Tracey Flaherty, fund managers and journalists dined on roast duck while discussing the U.S. economy, emerging markets and alternative investment strategies.
Considered one of the cheapest and most tax-efficient funds, the open-ended Gateway Fund has been practicing the same strategy since 1977. Using market volatility as a basis to generate cash flow and options to actively reduce downside risk, the fund's year to date return is holding steady at .018% through October 13, 2011, according to Lipper.
"The concept is that options are risky and used to speculate, but we use them in the exact opposite way. We use index options to reduce risk, dampen volatility and to address tail risk, which has to do with the distribution of returns," says Buckius.
The three-part strategy includes broad market exposure by owning stocks that track the S&P 500, selling index call options against the value of the portfolio to generate a measurable stream of cash flow and covered calls to lower risk and generate interesting rates of return.
"Corrections in the market have occurred but they don't happen often so we buy put options, which increase in value when markets fall dramatically. That creates a nice balance in our portfolio," says Buckius. "When volatility goes up our hedge is more effective. When markets fall and the fear index spikes, it gives our put options an opportunity to protect."
Launched last December, the Loomis bond fund adds value by shorting in order to preserve principal with a standard deviation of 4% to 6%. Its year-to-date return was negative 4.27 through October 13, 2011, according to Lipper. In a low-yield environment, concerns are shifting away from reinvestment-rate risk and more toward principal risk and how to generate a return, which is where alternative investments come in.
"Our fund is unconstrained by a traditional benchmark. We are more flexible. We take short positions in corporate credit, interest rates, currencies and treasury bonds and we have low correlation with traditional investments, " says Eagan. "We are not constrained only to invest in mortgages. We can go into non-investment grade sectors and non U.S. dollar denominated bonds around the world."
The new challenge is preserving principal as rates rise, according to Eagan. "In a secular, declining interest rate environment, it's easier to maintain and grow principal as a fixed-income investor, but as time goes on and you're reinvesting lower yields, you're caught in a trap. The goal is to get to a higher-level yield while preserving principal," says Eagan. "We truncate downside losses in alternative investments. It's slightly more risky in terms of volatility, but by investing in alternative investments we can diversify and capture as much of the upside as we can."
With its $45 million in assets, the Hansberger Emerging Latin America Fund returned a negative 21.80 year to date, according to Lipper.
Natural resources and a growing middle class are what make emerging markets attractive, according to Alzuru.
"Employment is strong and wages are growing. When the world realizes that 80% of the GDP of the world will come from emerging markets and 80% of consumers are in emerging markets, it will be a more accepted asset class or investment strategy," said Alzuru.
Until then, the Florida-based fund manager suggests introducing clients to the concept of investing in emerging markets in increments.
"Our approach has always been that a small portion of their portfolio should be invested in emerging markets. Start with a small position and build it up, which will help increase the base of that retirement portfolio especially those at a younger age who can tolerate more volatility," says Alzuru.
When asked how much investors can expect to pay for risk reduction, managers agreed that it is included in the expense ratio.
"There should not be any explicit cost plus to your investment product to get the benefits of risk management," says Buckius, whose fund's expense ratio is 94 basis points cheaper than most equity funds. "But there's no free lunch. If you are reducing risk, it's fair to expect that you won't fully participate on the upside. That's the value proposition we are trying to deliver. There's a natural tradeoff."
In order to cost effectively tailor risk to an investor's comfort level, Buckius suggests broader diversification in hedge funds, lower-risk dividend-income funds, and alternative fixed-income products that are reasonably priced that broaden out the asset allocation other than in stocks, bonds and cash.
A question about whether the U.S. would enter a double-dip recession caused Eagan to wax philosophical about Europe.
"A recession is already priced into the credit markets. What could drive us into a nasty recession is systemic financial risk that is centered in Europe, so if Europe cannot come up with a solution it will feed into lack of confidence and lower spending," says Eagan.
G20 finance ministers are seeking a broader plan to prevent the European debt crisis from engulfing big countries like Spain, which saw its sovereign credit rating reduced, a move that may deepen the impact of the debt crisis on European banks. United States Treasury Secretary Timothy Geithner has said a solution is needed to prevent Europe's troubles from infecting the rest of the world.
"The equity markets are more vulnerable than the fixed-income markets. I get paid while I wait for the market to bounce back. My portfolio is yielding 6% by investing away from the traditional benchmarks, such as the Barclays aggregate. We have no Treasuries," says Eagan.
Alzuru addressed questions about a Brazilian bubble causing a stir among Brazilian investors. The Brazilian economy, Latin America's largest, grew more than 7% in 2010 and is expected to grow between 4.5% and 5% in 2011, according to Capital Economics.
"With interest rates at 14% or so, there is a bit of a bubble. It's one of many bubbles that exist. It's not all rosy. The bubble is a response to currency being weakened from interest rates coming down," Alzuru said. "People in Latin America want to preserve wealth outside of their country. They want to make sure they have a portion of their nest egg saved elsewhere in a safe asset. It doesn't surprise me.