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A Rare Bird: The Tax-Efficient Alternative

Gateway enhances a long-short strategy with tax efficiency.

Philip Guziec, CFA, 05/16/2013

Alternative investments may have appealing attributes for investors, but tax efficiency is rarely one of them. Whether the alternative strategy is attempting to arbitrage small price differences between stocks, or shorting companies in anticipation of an imminent price decline, the nature of many alternative strategies generally leads to frequent realization of short-term capital gains. As a result, alternative investments are usually best held in tax-shielded accounts. However,
Gateway GATEX defies the tax inefficiency stereotype of alternative funds. Here's a deep dive into how the fund developed the tax efficiency strategy and how investors can capitalize on these tax benefits.

Harvesting Losses for Tax Benefits
Gateway follows a hedged-equity strategy that uses a combination of stocks and options to give investors tax-efficient exposure to the broad stock market with less volatility. The fund holds a basket of approximately 250 stocks optimized to mirror the S&P 500 index, but with a dividend-yield tilt. To generate income, the fund sells S&P 500 Index call options, with expirations approximately 30-50 days out and strike prices approximately at-the-money, on 100% of the notional value of the stock portfolio. The fund also protects against downside losses by purchasing S&P 500 index puts, with expirations 40-60 days out and strike prices approximately 6%-10% out-of-the-money. As the net income received from the options generates short-term capital gains, management sells losing stocks to offset option income. With the fund's current strategy and under current tax laws, investors who hold shares in taxable accounts only pay tax on the qualified dividends received on the underlying stocks (minus the expense ratio of the fund), or when they sell the fund shares. Barring extreme events on the last day of the trading year that would make tax management challenging, fund management simulations predict that the fund could avoid distributing a capital gain for at least the next two decades.

The Evolution of Gateway's Tax-Optimized Strategy
Gateway wasn't always so tax-efficient. In fact, when Gateway Investment Advisers was founded in 1977 by Walter Sall and a group of Cincinnati businessmen, the strategy was decidedly tax-inefficient. At the time the fund executed a covered-call strategy on individual stocks, without the protective puts, with Peter W. Thayer as manager (he would stay with the fund until 1997). The tax inefficiency was the result of a regulation known as the "short-short rule," which prohibited mutual funds from generating more than 30% of their income on positions held for less than three months. This regulation forced Gateway to realize long-term capital gains on some of the underlying stocks (to increase the total income denominator) and to use some less-optimal, longer-dated options. At the time, however, the strategy was so lucrative that taxes and hedging were an afterthought. From 1977 until 1985, the fund continued to sell covered calls on individual stocks, but in 1985, the fund migrated to selling options on the S&P 100, as those options became sufficiently liquid, and then to the S&P 500.

Besides the covered-call strategy mutual fund, Sall and his team also ran a separate-account strategy, which hedged some of the downside risk of the covered-call strategy with purchased put options.The stock market crash of Oct. 19, 1987, validated the protective put strategy (which was up approximately 10% that year, while the mutual fund lost about 5.7%) In light of this event, the board authorized the addition of protective puts in January of 1988. From 1988 through the first quarter of 2013, the fund has returned 7.8% with a standard deviation of only 6.6%, and an alpha to the S&P 500 of 0.9 annualized (using monthly data), a track record few long-only or alternative managers can boast.

In 1997, the short-short rule was repealed, and the fund was no longer forced to sell stocks just to meet the 30% threshold. Also in 1997, portfolio manager Peter W. Thayer left the fund and J. Patrick Rogers, who had joined the fund in 1994, took the helm. Shortly afterward, a new tax headache replaced the short-short rule. During the stock market correction of 2000, the fund's option positions profited approximately 15% and used up all of the available tax loss carryforwards from previous years. The fund distributed a 9.7% capital gain to investors for tax purposes, even though the fund only returned 6.6% for the year. Needless to say, investors were unhappy. The solution came to management the next year, when the S&P 500 fell 12%. The fund once again generated approximately an 8% profit from its option positions, which partially offset the losses of the declines underlying stocks, resulting in a net 3.5% loss for the year. Like Alexander Fleming noticing that bacteria wasn't growing near the mold in one of his petri dishes, management noticed large unrealized tax losses on a small number of high-flying tech companies that had become almost worthless. Management decided to sell some of the biggest stock losers in the portfolio to offset option income without materially impacting the returns relative to the S&P 500. The fund had almost no capital gains distribution in 2001. Over the subsequent two years, management harvested some tax losses on the stocks to offset option gains and developed a tax-optimized strategy, which launched in 2004. The strategy has avoided distributing capital gains since 2001, and as of May 10, 2013, the fund has a tax loss carryforward equal to about 12% of the value of the fund. The one material risk to the tax efficiency is the impact of redemptions. If investors were to leave the fund in scale, after the tax loss carryforwards were used up and all losing shares of stock were sold, the fund would eventually have to sell underlying holdings with capital gains in order to meet the tax redemptions, generating a tax liability that would be borne by the fundholders.

Potential Tax Legislation
As evidenced by the impact of the short-short rule on the fund, the success of Gateway's strategy is dependent on securities and tax regulations. In fact, as of this writing, a legislative proposal for the tax treatment of derivatives could put the fund's tax strategy at risk. The proposal would treat all profits from option positions as ordinary income, preventing the fund from offsetting gains with losses on the underlying shares. The proposal would also treat all option positions as if they had generated a sale of the underlying security at year-end. While this proposal may proceed no further down the legislative process, its existence highlights the vulnerability of tax-efficient strategies to changes in regulation.

Putting Gateway's Tax-Efficient Strategy to Work
For now, at least, investors can take advantage of Gateway's two value propositions: superior risk-adjusted returns to the S&P 500 and tax efficiency. For most investors, the fund can be used as a low-volatility replacement for some core equity exposure. The fund targets approximately a 0.4 beta to the market, so it won't make as much money in rallies, but it won't lose much in downturns. At 0.94% for the A-shares, the fees are lower than the average large-cap long-only stock funds.

For older investors looking for income, this fund may have even more benefits. Rather than increase one's weighting to high-yielding long-only fixed-income products, which may result in large losses in the event of a credit correction or a rise in interest rates, one could allocate to a hedged-equity product such as this one.

Philip Guziec, CFA, is Morningstar's derivatives investing strategist. He leads Morningstar's OptionInvestor service, which applies Morningstar's fundamental research methodology and fair value estimates on 2,000 stocks to uncover option investing opportunities. Guziec joined Morningstar in 2003 after a career as an engineer and management consultant. Learn more about OptionInvestor.
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