An Open-End Means to Hedge Volatility

Josh Charney: Hi, my name is Josh Charney. I'm a fund analyst here at Morningstar. And here with me today I have Eric Metz. He is with the RiverNorth Dynamic Buy-Write fund.

Eric, thank you for joining me today.

Eric Metz: Thank you, Josh.

Charney: So Eric, can you explain to some of our viewers out there what exactly is a buy-write fund?

Metz: Sure. So, a buy-write is by no means new, and it's been around for approximately 20 years. The most visible buy-write in the marketplace today is the CBOE's BXM Index. And what that constitutes of is the S&P 500, and then subsequently than selling a call option on the S&P. But it could just as easily be a single security such as Microsoft in which you own Microsoft and then sell a call option on Microsoft. So, you can either take a buy-write in a single-security form or in an index form.

Charney: So, there are definitely a lot of nuances to all these types of strategies. Can we kind of explain what are some of those nuances?

Metz: Sure. Well, unlike an equity portfolio in which you have a basket of securities in a diversified manner, what a buy-write would do is take that same portfolio and then sell call options and often times in a systematic fashion. There is an expiration and a maturity and a strike price for each option, and so the portfolio manager would then select the maturity and the strike price on each individual security. What that does is it changes the risk/reward profile of that portfolio by mitigating its volatility and potentially enhancing its return.

Charney: So, we kind of looked at where these strategies are in terms of vehicles, and we found that there are 32 buy-write strategies in the closed-end fund world. There are a few exchange-traded funds. There is a just a handful of open-end funds that you know strictly follow this type of strategy. So, why do you think that this strategy is predominantly in the closed-end fund space?

Metz: That's a great question. Coming at RiverNorth, we are predominantly a closed-end fund shop, so we have evaluated the same thing. The reality is that the closed-end fund arena has a fixed pool of assets, and when you're managing an options portfolio because the options portfolio will change the risk/reward profile of your portfolio so dramatically on any given day, managing that portfolio with a fixed pool of money is a much easier task.

We launched an open-end fund, and hence the name Dynamic, because the dynamic nature of the fund will allow us to manage the open-ended form without losing any source of alpha that we see in the marketplace.

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Charney: So, you don't think for example that that you made any trade-offs or sacrifices with this open-end fund?

Metz: No. In fact, we think there was a void in the marketplace for this type of fund, which is why we launched it. The BXM, if you will, has done everything in a systematic nature on purpose. And what we try to do, hence the name again, is manage the fund with volatility in mind. So, in addition to being open-ended with a variable pool of assets, we want to keep the volatility flavor of options trading in the forefront of the source of alpha of the strategy.

Charney: And just looking back at how these funds have performed, in 2008 they fell roughly by 26%. What can investors expect over various market cycles?

Metz: Well, buy-writes by nature when you're selling call options on the aggregate, you create a different set of risk and reward embedded in the portfolio from the nature of the options. So, what that does is it will cushion the blow on the downside--potentially you give up some of the reward on the upside--but all the while you are reducing the portfolio's volatility. And the main factor whenever you're investing in a buy-write fund is to understand where you are in the volatility cycle. So, a large determining factor of how the fund will perform over a given time frame is where you are in the volatility cycle, not necessarily whether the market goes up or down.

Charney: During the last couple of years, these types of strategies perform roughly 5% a year. So that's [not to say it they haven't had] out-of-the-park blockbuster returns, but it has been a little low. So, what are some of the challenges and some of the headwinds in this space?

Metz: Right. Well, if you look at just a buy-write over a longer time frame, the risk/reward profile becomes much more attractive. So, in any given short duration, yes, you might be correct, but the longer your horizon, the Sharpe ratio of the buy-write is often exceeding the S&P 500. So, the longer your horizon, the strategy tries to achieve S&P-like returns with a fraction of its volatility.

And one thing that we at RiverNorth try to focus on--and when you're managing it in a dynamic nature--is not allowing the relative underperformance to the S&P to occur even in short durations. So, we try to alleviate that by managing in a much more dynamic nature.

Charney: Can you talk about that dynamic nature and how you use that to manage risk in the fund?

Metz: Sure. Every portfolio has a beta. If you have a long-equities portfolio and it’s diversified, it's probably approximately 1. The BXM, which is the CBOE BuyWrite index, they would pitch a beta of much less than that, approximately 0.5. What we do is we dial it down even further to roughly a third of the S&P, so 0.33 beta. What that allows us to do is be very flexible in allocating capital to opportunities when we see them.

So, if there are opportunities, we can increase our beta. Investing the whole premise in the way we view the world is that, we want to achieve the highest reward and take the least risk to do so. So, if there is potential reward, we want to try to capture that. And to do so, we have to take some risk, but let's mitigate that risk, which is why we keep that beta a little lower.

Charney: Well, Eric, thank you for joining me today and thank you at home for listening.

Metz: Thank you, Josh.