Back in 1977, Walter Sall, a pioneer in the use of options in investment strategies, founded what could be called the “grandfather” of hybrid investment strategies in a mutual fund format. His goal for the Cincinnati-based Gateway Fund was to give the average investor access to an options-based investment strategy designed to make market downturns less painful while providing some upside in bull markets.

Michael Buckius, who joined Gateway Investment Advisers in 1999, said few investors were thinking about downside protection at that time. Tech stocks were continuing their upward trajectory.

“People were making 7% to 10% a month in a raging bull market,” Buckius recalls, “so achieving those returns over the course of a year with less risk was not mainstream thinking.”

“We were a niche back when I started at the firm, and we’re a niche now,” says the 48-year-old Buckius, who is now Gateway’s chief investment officer and the senior portfolio manager for Gateway Fund.

But that niche is growing, he says, as market volatility ticks up this year and alternative investment strategies become more mainstream.In his previous life, Buckius had been an options trader at a regional brokerage house. He joined Gateway because he believed in the merits of safety nets, even when the stock market is roaring ahead.

Nowadays, he says, investors are paying more attention to risk than they did back when he started and looking for different tools to control it. While the traditional route for dampening portfolio volatility has been moving some assets from stocks to more predictable bonds, the rising interest rate environment makes doing so a less attractive option than it used to be. With that in mind, he says, some investors use the Gateway fund as a fixed-income alternative with a low correlation to both the stock and bond markets.

Others view it as a core equity strategy that aims to minimize downside risk, or as a component of an alternative investment program.

Bear Market Star

Regardless of where the fund fits into a portfolio, history shows that the Gateway Fund truly shines during bear market slides. In the three years from 2000 to 2002, when the S&P 500 plummeted nearly 40%, the fund’s return was almost flat. In 2008, when the index lost 37% of its value, the fund was down just 14%.

Its more recent history suggests it also offers downside protection during shorter-term declines. Between March 1 and mid-April 2017, the S&P 500 fell 2.58% while the Gateway Fund fell only 0.49%. In February 2018, Gateway’s drop of 1.75% was mild compared with the 3.7% decline of the index.

“Bear markets provide us with a proof point that the strategy is doing its job,” he says. “But even hedged the way we are, it never feels good to go through a bear market.”

Surprisingly, inflows to the fund don’t spike when a downturn hits, he adds. “Even with our fund it takes a while for people to feel more comfortable moving back into the market,” he says. “I’d say we’ve seen more of a steady increase in money moving into the fund over the years rather than sharp spikes during particular short-term periods.”

While investors might reap benefits from downside protection, they should be prepared to underperform the stock indexes during bull markets. Over the last 30 years, an index tied to the Gateway Fund had a 7.3% average annual return, well below the 10.7% return of the index. That performance gap with the index has grown even wider in the past decade during the bull market.

But over the long term, the fund has also been less than half as volatile than the broad stock market. It’s achieved that feat by using an “options collar” to constrict price fluctuation on both the upside and downside.

The strategy is built around a large-cap U.S. stock portfolio designed to mirror the S&P 500. The collar is formed when the managers sell index call options (options to buy at a specified price over a defined period) with a strike price that closely matches the current level of the S&P 500. Using some of the money generated by the sale of those options, they purchase index put options (options to sell at a specified price over a defined period) that are typically 8% to 10% below the weighted average call strike price. The amount of cash the fund earns from selling calls depends in part on how volatile the markets are. When volatility is below average, the fund makes less from option sales; when volatility increases, it makes more.

Beating The Quants

The managers don’t try to time the market or make market calls by making drastic changes to the size of the options hedge. Instead, the notional value of the call options always approximates over 95% of the portfolio, and the fund typically diversifies across a combination of six to 10 strike prices and expiration dates to limit exposure to any one contract. The notional value of the put options typically approximates 100% of the portfolio, and also diversifies across strike prices and expiration dates. Gateway does not use leverage in its investment program.

Nonetheless, even against this consistent backdrop, active management plays a major role in influencing returns. At times, the managers may not always hedge the entire portfolio with puts, which increases exposure to a market decline. They can adjust strike prices, depending on market conditions, and tailor strategies to market volatility. While they typically replace options contracts before expiration, they can vary the timing of the replacements.

The active approach contrasts with that of most other hedged mutual funds and ETFs, which typically have strict quantitative rules, statistics triggers or algorithms that drive management decisions. “The markets have a way of presenting new and unusual combinations of circumstances that can confound algorithms,” Buckius says.

“Each market environment presents a unique combination of opportunities and risks, and decision-making based on judgment and experience is more reliable than quantitative triggers or rigid rules-based approaches.”

He adds that the firm’s long history in the business also provides more of a track record than that of newer rules-based alternatives, and most members of the management team have been with the firm for over a decade. With an expense ratio of 0.77%, institutional class shares have lower expenses than many stock or liquid alternative funds.

Another distinguishing feature of Gateway is that it sticks exclusively to index options because these have lower transaction and implementation costs than options on individual securities, as well as more predictable settlement features. The strategy also makes the fund more tax-efficient than many of its competitors. With options on individual stocks, profits are taxed at short-term capital gains rates.

In contrast, index options are subject to the 60/40 rule, with 60% of profits taxed at favorable long-term capital gains rates and 40% subject to short-term capital gains treatment. Because the fund uses index options and harvests tax losses, it has not had a capital gains distribution since 2000.

A More Volatile Future?

Market volatility is important to the fund because it allows the managers to capitalize on the spread between the realized volatility of the market and the implied volatility priced into the index options it sells. When stock indexes are cruising along smoothly, as they have been for most of the last decade, the Gateway Fund’s returns tend to lag the indexes by a substantial margin. On the other hand, when volatility rises above historical averages, the fund has historically either outperformed the market on the upside or provided more protection on the downside.

Earlier this year, a sharp 10% decline in the market in a matter of days stoked fears that the long upward market trajectory would be ending. Despite political tensions, including Middle East unrest, North Korean nuclear threats and China’s growing influence, the market remained evenly tempered and stocks advanced steadily last year. After the sharp decline, market volatility rose but has still been within historical averages recently.

Buckius says that if volatility returns to equity markets for the rest of 2018, the trigger may more likely be tied to earnings or the economy than to politics. With equity market valuations high and the Fed committed to normalizing monetary policy, there may be less valuation support and less policy support to prevent the next pullback from developing into a correction, or worse. And if earnings growth fails to meet expectations and the market softens, the Fed’s response could be muted unless it is willing to abandon its commitment to raising rates.

“I’m terrible at predicting where the market might be headed,” Buckius says. “But at current valuations, a lot of the right things have to fall into place to keep the bull market running.”