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One of the Oldest Alternatives Shops Expands Its Offerings

Same approach, different domain.

Mallory Horejs, 04/26/2012

Liquid alternatives are still a relatively new concept. Less than a third of the 320 alternative mutual funds tracked by Morningstar have a five-year track record. Within this nascent universe, however, Gateway fund GATEX is one of the most well-known. Launched in December 1977, this fund has had a generous head start on the majority of registered alternative products.

On March 30, 2012, Gateway Investment Advisers launched its second mutual fund offering, Gateway International GAIAX, with $20 million in assets. Managed by¬¬¬¬ Michael Buckius and Kenneth Toft, this fund employs the same options strategy that has worked for Gateway fund for more than three decades, but within the wider world of international equities. Given the longevity and consistent risk-adjusted returns of the firm's flagship fund, this new offering certainly merits a closer look.

A Well-Honed Process
Patrick Rogers has managed Gateway fund’s index options-based strategy since 1994. Rogers and his team generate profits by selling S&P 500 index call options that are at-the-money on average. To cover the calls, he selects a broadly diversified portfolio of stocks that resembles the index. When equity markets rise, gains on these stocks offset losses on the call options. Long puts on the index are used to hedge downside risk.

Rogers also strives to be tax-efficient--a rare practice in the realm of alternative mutual funds. By harvesting losses on individual stocks, he has avoided distributing any capital gains to shareholders since 2001.

This 3-star fund has certainly had its ups and down, but as of late, things are looking good--the hedged-equity strategy returned 3% last year, outperforming the S&P 500 Index (which rose 2.1%) and taking only one third of the market's risk (its weekly annualized beta was 0.34). The average long-short fund, on the other hand, lost 2.8%. As of March 2012, Gateway fund had $5.7 billion in assets, making it the largest offering by far in the long-short equity category.

Going International
Gateway's new international offering applies the same logic to six regional indexes: Australia’s S&P/ASX 200, Europe’s Euro Stoxx 50, Hong Kong’s Hang Seng, Japan’s Nikkei 225, Switzerland’s SMI, and the United Kingdom’s FTSE 100. The six sleeves are weighted according to their approximate weight in the MSCI EAFE Index and are periodically rebalanced. Certain countries (Singapore, for example, which constitutes 1.8% of the MSCI EAFE Index) are excluded because of small index representation and/or undeveloped index option markets. As in the flagship fund, tax efficiency is a priority.

Although the fund is brand-new, comanagers Michael Buckius and Kenneth Toft aren't new to this hedged equity strategy. Buckius joined Gateway in 1999 and has comanaged the firm's flagship fund alongside Rogers since 2008. Toft has served as a member of Gateway's investment management team since joining the firm in 1992. For this portfolio, Buckius focuses primarily on the European portion and Toft oversees the Asian allocations.

Reasonable fees also set this fund apart from other recently launched alternative mutual funds. Gateway Investment Advisers offers this strategy to investors through three share classes: A, C, and Institutional. These products charge prospectus net expense ratios of 1.35%, 2.10%, and 1.10%, respectively, and, like the firm's flagship fund, they are some of the most cost-effective options in the long/short category.

What Investors Can Expect
Options strategies like this fare best in market environments where implied volatility is higher than realized volatility (which happens often because people tend to overestimate future volatility). The strategy also benefits when the price of index puts (downside protection) are cheap relative to the written calls (premium income). Because management writes calls on 100% of the portfolio, however, investors should bear in mind that this fund's upside potential in less-volatile markets is capped.

Conversely, the fund will struggle in environments where realized volatility exceeds implied volatility. Spikes in realized volatility skew the S&P 500 Index option markets, making covered-call writing less profitable relative to the cost of the fund's downside protection. Management experienced this type of undesirable market environment in the fourth quarter of 2008 and first quarter of 2009. The flagship Gateway fund returned negative 11.2% and negative 6.5% for those two periods, respectively, underperforming the long-short category average's 8.4% and 4% losses.

Lastly, executing this strategy in the international arena inevitably poses additional tracking and liquidity risks. First, whereas the flagship fund invests and hedges around a single index (S&P 500 Index), this new offering incorporates six different indexes, making close tracking a greater challenge. Second, international stocks and index options may not be priced as efficiently because of lower liquidity (although management attempts to minimize this risk by screening out index constituents with small market caps and low trading volume and sticking to liquid, efficiently priced options).

Although increased volatility is often a concern when investing internationally, management avoids this risk to some extent by restricting itself to developed international markets. And while some developed markets exhibit more volatility (for example, Australia, Hong Kong, and the eurozone), others exhibit fairly similar levels (for example, Switzerland, Japan, and the United Kingdom) to the S&P 500 Index.

Use in a Portfolio
This young fund promises to be a good choice for investors seeking risk-managed exposure to international stocks. Allocations could be funded from either the long-only international-equity sleeve or the alternatives bucket. There's already lots to like about Gateway International--a proven strategy, a seasoned management team, and low fees that won't eat into profits. Time will tell if Gateway's hedged equity approach can deliver in a new domain.

Mallory Horejs is an alternative investments analyst with Morningstar.
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