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Know Your Options

Long-short funds that employ options-based strategies can lead to a wide range of outcomes.

Over the past couple of years, a slew of new mutual funds employing options-based equity strategies have entered the marketplace, and they often end up in the long-short equity Morningstar Category. These funds claim to offer some attractive features, including an additional stream of "income" wrung from the writing of put or call options, as well as the potential to hedge against stock market downturns. Though it is true that investors can benefit from these characteristics, it's also true that options strategies come in a staggeringly complex range of combinations and correspondingly diverse outcomes. One should never assume that just because a fund touts its options prowess that the strategy will provide sure protection in a downturn; the devil is always in the details with these funds.

To illustrate the potential differences, I'll take a look at how three options-based funds, all of them Morningstar Medalists, performed during one of the steepest parts of the August 2015 U.S. market downturn. The three funds are Silver-rated

Below are the returns for each fund from Aug. 17 through Aug. 24, 2015, a stretch when the S&P 500 was down more than 9%.

Before delving into the reasons for the stark differentiation, it's worth making one important point: Each fund's return is not on its own an indication of whether the fund succeeded. The more relevant question is whether a given fund performed in line with expectations, based on its design. And to lead with a spoiler, the answer in each of these cases is "Yes."

Let's begin with the fund that did worse during the August stretch, Swan Defined Risk. Like many options-writing strategies, the long-investment core of the portfolio is fairly straightforward: in this case, an equal-weight version of the S&P 500 built through nine equally weighted S&P 500 sector ETFs. Manager Randy Swan constructs a hedged component around the portfolio, buying long-term, at-the-money puts designed to protect the fund against market drops of 10% or greater. At the same time, he sells out-of-the-money calls and puts on the S&P 500, which produces a cushion of premium income. He resets the options approximately every 30 days.

Inherent to the fund's design is the risk of loss during sharp but brief market sell-offs; this is exactly what happened in August, when the fund's 7.8% loss caught nearly all of the S&P 500's 9.4% drop. The fund's short put positions incurred unrealized losses as volatility spiked, while its long puts were not in the money as the market fell less than 10%. Management says that the fund is designed to protect against bear market conditions, not short sell-offs. Indeed, the separate account version of the strategy, which has been around since 1997, held up well in both 2000 and 2008. Why not set the hedge closer in, you might ask? Because then the price gets higher. Think of it like auto insurance: You can choose a $500 deductible and pay a higher premium or a $3,000 deductible and pay a very low premium. It depends on where you set the trade-off between protection and cost. Swan believes that its investors are most concerned about hedging against an extreme market event.

The middle performer of this trio was Gateway. This 35-year-old fund also uses a version of the S&P 500, in this case its own hand-built portfolio designed to provide a dividend tilt on the index. The options component of the strategy is a fairly straightforward collar approach. Management sells S&P 500 call options, with expirations about 30-50 days out, on 100% of the stock portfolio. The hedge consist of S&P 500 puts, with expirations 40-60 days out and strike prices approximately 8% out of the money (typically they are laddered across a range of strike prices).

Gateway's approach curtails upside in a rising market, and that's led the fund to trail on a relative basis in recent years, with the low-volatility environment a further detractor. But at roughly 8% protection, the fund provides slightly better short-term protection than Swan, and because it only writes calls, it is not exposed to as much downside risk. Those factors played out in August, as the fund's 4.6% loss was only about half that of the S&P 500 and in line with the fund's historical beta of about 0.5. A strong point in Gateway's favor is the consistency and predictability of its approach.

Schooner, which produced the best return out of not only these three options-based funds but the entire long-short equity category during the Aug. 17-24 stretch, also uses a collar strategy but takes a far more dynamic approach than Gateway and Swan Defined Risk. Management adjusts the level of put protection for the value-tilted S&P 500 portfolio depending on its forecasts for the cost of volatility and market risk in what is essentially a contrarian or mean-reversion approach; when volatility is cheap, it will aim to increase the fund's optionality on both the upside and downside, for instance.

Over the past two years, volatility has been unusually low and cheap, so throughout 2015 Schooner increased its put protection substantially. Although that was a detrimental play while the S&P 500 was rising, as hedging costs eat away at returns, the protection kicked in during August's downturn, leading to the fund's 4.16% return during the week under review and 2.3% for the month (versus negative 6% for the index and negative 3.5% for the category). Still, the downside protection has not overcome the fund's positioning for the full year. Schooner's negative 6.23% return for the year to date through September is near the category's bottom quartile and trails both Gateway and Swan Defined Risk. The fund's active approach to the options overlay offers the potential for improved returns over more static approaches, but it relies on an environment for options volatility that has been largely absent during its existence.

Each of the above strategies can serve a purpose for investors, and as our Medalist ratings for the funds show, we have confidence in the management teams and methodologies behind these vehicles. But given the many permutations of options-based strategies populating the landscape, advisors and investors must do their due diligence to make sure they understand the design of a fund and how it is expected to perform in different market conditions, particularly down markets. If a strategy seems too complex or is not sufficiently transparent, it's best to stay away. Even more concerning is that some of these other funds, even ones that contain "hedged" in their name, don't actually provide protection on a consistent basis. True, the premiums from their options-writing sleeves can partially offset short-term losses, but without actual protection in the form of long puts or analogous mechanisms, investors will be fully exposed to losses during a sustained downturn. And at that point, you might just be out of options.

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