Phil Guziec: Hi. I’m Phil Guziec, alternative investing strategist with Morningstar, and I'm here with Harry Merriken, chief investment strategist of Gateway Fund Advisors. Thanks for joining me.
Harry Merriken: We appreciate the opportunity to be here.
Guziec: So talking about Gateway Fund. It's a hedged equity fund that’s tax-efficient. Can you walk me through the value proposition of the hedge? And then maybe we’ll talk a little bit about the tax efficiency.
Guziec: Sure. What we feel Gateway is, and Gateway Fund has been around for about 35 years, is that our investors are investors who want exposure to the equity markets, but are concerned about the risk involved in owning equities. In particular, over the last 35 years we’ve seen a number of bear markets, particularly since the turn of the century. So what we try to do at Gateway is give people the opportunity to have equity exposure, but to mitigate the downside and limit that volatility. We do that with a two-pronged hedging program. The first part of the program is specifically designed to limit volatility. We're looking at the total return of equities historically in the neighborhood of 10%, the majority of that return comes from capital gains. The rest, obviously, is from dividends. Dividends are somewhat stable, somewhat predictable; nothing guaranteed, of course. So most of the volatility of owning equities comes from the capital gain or price fluctuation.
So at Gateway we do something very simple. We simply sell off the upside on our stock portfolio. We own a stock portfolio that replicates the return of the S&P, and we sell off the upside in return for an option premium that we receive.
Guziec: So instead of the uncertain gains, you’re smoothing it all out with a certain payment today?
Merriken: Exactly. Once we sell that call, we know how much premium we have to earn, and the return is going to be equal to that amount of premium, and since we sold off the upside, it's the amount of premium less any depreciation in the stocks. Now, we can stand a certain amount of depreciation because we have the option premium as an offset. But if we get a significant sell-off in that stock portfolio, we want to be protected so that we mitigate the downside, and we, using our moderate return or income strategy, were able to make back that loss. So we take a portion of the option premium from the calls--and this is where the second prong of the approach comes into play--and we buy out-of-the-money put options.
Guziec: So that protects you against your catastrophic events…
Guziec: Terrible market conditions.
Merriken: The cataclysm, the market cataclysm. To be honest with you, we’ve seen potentially a couple of those start to unfold, but in many cases government intervention or some sort of monetary intervention has prevented an extreme meltdown of the markets.
Guziec: But having those puts in place even for temporary losses is comforting for a lot of people.
Merriken: Absolutely. It allows them to stay the course, as I said, to remain invested in equities, and what we believe is that the key to successful investing is to remain invested. That's what we’re trying to allow people to do.
Guziec: There is a unique spin on the fund, as well, in that it’s tax-efficient. Most alternative investment strategies are highly tax-inefficient.
Guziec: Could you talk a little bit about how that works and how that's valuable to what type of client?
Merriken: Certainly, for our taxable clients, the tax situation with mutual funds is that mutual funds are required to distribute gains at the end of each year, and because we use index options to hedge our portfolio--index options are marked to market at the end of year--and any gains that you've realized from your options must be paid out to shareholders, unless they can be offset against losses inside the fund. Since our underlying portfolio is a portfolio of actual stocks, and stocks tend to have unrealized gains or losses, we would have a realized gain where we’d be distributing out against the unrealized loss. So the clients would actually be paying taxes on hedging benefits, reduction in losses. So what we do is actually realize the losses in some of the stocks, enough of the stocks to offset the gains, and thereby avoid having to pay the capital gain. We've done that now since 2000.
Guziec: And how do you do that? If you are using the S&P 500, being 500 stocks, index options, but then you're selling some of them to realize losses, how do you manage that portfolio?
Merriken: We actually create an optimized portfolio that will correlate to the S&P but is not the S&P. So if we have to sell 25 names to realize losses, we can do that and replace them with another 25 stocks. And the actual universe that we use to create that portfolio is potentially all listed, traded stocks. So our universe, we have a universe of about 4,000 names that have adequate liquidity for us to own in the fund because of the size. If we have to sell 25, we simply reduce the universe by 25 names and create a new optimized portfolio from the remainder for that 30-day period to meet the wash-sale requirement.
Guziec: What kind of clients most value this tax efficiency? What do you hear from your clients?
Merriken: Yes, definitely the high-net-worth clients. The many mutual funds that don't practice this tax efficiency, I think, rely on the clients having losses in other parts of their portfolio and offset it. But what we have found in the past is that clients really do value the tax efficiency and have led us to adopt this course of action.
Guziec: Great. Well, a unique product. Thank you talking to us.
Merriken: You bet.
Guziec: I’m Phil Guziec. Thanks for watching.