A Solid Choice for Conservative Equity Exposure

The following is our latest Fund Analyst Report for Gateway GATEX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Gateway's risk-tempered portfolio results in a smoother ride, and its long-term steady performance, veteran team, straightforward approach, and reasonable fees support its Morningstar Analyst Rating of Silver.

Relative to the S&P 500, the fund achieves less volatility in its returns by holding a large-cap U.S. equity portfolio designed to track the S&P 500 and employing an options collar, which sets a cap and floor on returns. To create a collar, the fund sells, or writes, roughly at-the-money index calls and uses a portion of the premium (or income) earned from the sale of calls to buy index puts that are typically 8% to 10% out of the money. Both the calls and puts are usually equal to 100% of the portfolio's notional value.

Downside protection is key to the fund's strong long-term risk-adjusted performance. During the 2008 financial crisis, as well as during sudden sharp market corrections (such as in the summer of 2015 and in the first quarter of 2018), the fund's declines were less than half of those of the S&P 500. As a result, the fund's 20-year Sharpe ratio of 0.48 was close to the S&P 500's 0.46. But the recent multiyear equity market rally, combined with record low volatility, has been a headwind for this fund. The cash generated from call writing is used to buy put protection, and there is typically excess cash that is additive to the fund's returns. But during a strong market rally, this excess premium does not offset the missed opportunity of participating in the rally.

Unlike most options-based strategies, this fund has a long 30-year track record. Its investment team is also quite seasoned. Current skippers Paul Stewart, Michael Buckius, and Kenneth Toft have each worked at Gateway for about 20 years; the first two have been named managers on this fund for about a decade. As for fees, this fund falls in the pricier alternatives group, but at 0.70% for its institutional shares, its fees are comparable against large-blend and allocation funds. The fund is also more tax-efficient than those peers. This is a solid holding for investors who look for a more conservative equity exposure.

Process Pillar: Positive | Patricia Oey 09/07/2018

A time-tested, prudent approach underlies this fund's Positive Process rating.

This strategy, whose current process has been in place since 1988, uses a combination of stocks and options to provide tax-efficient exposure to U.S. large caps with less volatility. First, the fund employs a rules-based multifactor model to select a basket of approximately 250 stocks optimized to track the S&P 500. The options portfolio, on the other hand, is actively managed. The managers sell S&P 500 call options to capture equity market volatility as a cash flow stream, as well as manage the portfolio's beta to around 0.4 to the S&P 500. These call options generally have expirations approximately 30-50 days out and strike prices approximately at the money on 100% of the notional value of the stock portfolio. They focus on selling calls with the highest implied volatility, as these command higher premiums.

For downside protection, the managers use some of the cash from the call options to purchase S&P 500 puts with expirations 40-60 days out and strike prices approximately 6% to 10% out of the money. Coverage is typically close to 100%. However, the managers do opportunistically sell some of their "insurance" when there is a sudden sharp market downturn to generate additional income, as these puts become more valuable. In these scenarios, the managers expect a quick correction, but if markets continue to decline, the fund could be exposed to more downside risk.

Historically, the equity portfolio's sector weights have matched those of the S&P 500 within 1%, and tracking error has been less than 50 basis points a year. Annual turnover has averaged about 16%, higher than the 3% to 4% range of the index.

In the options portfolio, written calls typically have six to 10 combinations of strike prices and expiration dates to limit exposure to any one contract. But overall, the weighted-average strike price is usually at the money. The purchased puts are also diversified across strike prices and expiration dates, but for these options, the weighted-average strike price is usually 6% to 10% below the weighted average call strike price, as this combination provides protection at a price that maintains attractive net cash flow from call writing. For the puts, the managers try to avoid contracts with richly priced implied volatility--investors often will pay a premium for portfolio insurance, and this pushes the implied volatility skew steeper for these options. The managers use only cash-settled index options and typically roll their options prior to expiration.

The fund has not distributed a capital gain since 2001. This is partly because gains and losses from options contracts are treated as capital gains. So, the managers can use realized losses from options to offset realized gains from the equity portfolio, and vice versa. During market declines, they may harvest losses from the equity portfolio.

Performance Pillar: Neutral | Patricia Oey 09/07/2018

Relative to peers that employ a similar strategy (large-cap exposure with an options collar), this fund has performed similarly, leading to a Neutral Performance rating.

Performance has been sluggish during this multiyear market rally. Over the trailing five and 10 years, the fund's Y shares returned 5.9% and 3.8% versus the S&P 500's 14.5% and 10.9% over the same time periods. Another headwind has been low equity market volatility, as Gateway seeks to capture a volatility premium via its options strategy. Over the past few years, the income from call selling has not been able to offset the equity portfolio's missed upside participation.

That said, the fund has generally delivered on its goal to provide equity exposure with reduced downside risk. In periods of sharp market declines, such as in January/February of 2018, the summer of 2015, and the 2008 financial crisis, this fund's declines have been less than half that of the S&P 500. Over the past decade, the trailing 36-month beta has remained close to 0.4, and volatility was 6.7% versus the S&P 500's 14.7%. With lower volatility, over periods longer than 15 years, the fund's Sharpe ratio has been close to that of the S&P 500.

Given the fund's 0.4 beta, its performance can be compared with that of balanced fund with a 40% allocation in equities. One advantage this fund has over a balanced fund is that it is not exposed to rate risk.

People Pillar: Positive | Patricia Oey 09/07/2018

This fund's experienced crew earns a Positive People rating. Paul Stewart is the longest-tenured member of the four-person portfolio manager team and is the point person for the equity portfolio. He has been a named manager since 2006 and has been at the firm since 1995. In 2013, Stewart became CEO and president of Gateway, after then-leader Patrick Rogers left the firm to pursue other opportunities. Rogers had also served as portfolio manager for the Gateway fund from 1994 to 2013. Michael Buckius, who oversees the options strategy, became a named portfolio manager in 2008 and has been at the firm since 1999. He also serves as the firm's CIO. Kenneth Toft has been at the firm since 1992 and is a named comanager on a number of Gateway strategies. Daniel Ashcraft recently joined the portfolio manager team in 2016 and has been at the firm since 2009. Other team members include trader Michael Dirr, who has been at the firm since 1999, and associate portfolio manager Mitchell Trotta, who joined the firm in 2016. Buckius, Toft, and Ashcraft also comanage the buy-write fund Gateway Equity Call Premium GCPYX. Gateway was sold to Natixis in 2008. With the exception of Rogers, the three veteran portfolio managers have remained at the firm.

Manager ownership is good. Stewart and Buckius each have more than $1 million invested in the fund, Toft has between $100,000 and $500,000 invested, Ashcraft $10,000 to $50,000.

Parent Pillar: Neutral | 08/03/2017

Paris-based Natixis Global Asset Management is the parent to a number of different asset managers globally, including Natixis AM in France and Loomis Sayles and Harris Associates in the United States. These affiliates have maintained a large degree of autonomy, both in operational terms and in terms of their investment philosophies. The quality of investment culture varies significantly from one subsidiary to another. The results of the teams at Loomis Sayles and Harris Associates, manager for the U.S. Oakmark funds, for example, are excellent, communications with investors are of high quality, and fund launches have been minimal. NGAM’s latest acquisition, DNCA, has also begun improving its funds’ fee structures since joining the fleet.

On the other hand, the results obtained by Natixis AM are more mixed, and its teams are less stable. Furthermore, in July 2017, the French financial regulator Autorité des Marchés Financiers imposed a EUR 35 million fine on Natixis AM for failings relative to its range of formula-based funds, arguing that the firm had overcharged investors and had failed to adequately disclose charges in the funds’ filings. The sanction on Natixis AM thus weighs negatively on our assessment of the group’s stewardship, but we recognize that strengths in other parts of the organization, particularly in the U.S.-based affiliates, partly compensate for this weakness, resulting in a Neutral Parent Pillar rating.

Price Pillar: Positive | Patricia Oey 09/07/2018

All three share classes of this fund have fees that are below average relative to equity alternative peers. The fund earns a Positive rating for Price.

The institutional share class holds about 75% of the fund's assets. With an operating expense ratio of 0.70%, it is significantly below the equity alternative median (for institutional share classes) of 1.40% and about average relative to conservative-allocation peers.

From a tax perspective, this fund has not distributed a gain since 2001, and its five-year tax-cost ratio of 0.56% is less than half than the average for allocation and equity funds.

Financial professionals are accessing this research in our investment analysis platform, Morningstar Cloud. Try it today.