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.