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Why This Options-Based Fund Imploded During the Sell-Off

Gretchen Rupp
Karen Wallace

Karen Wallace: Though last week's market volatility may have come as a surprise to many investors, it registers as only a small blip in the context of a longer-term market cycle. But short-term dislocations like these can be helpful in that they allow investors to get a sense of where a fund's bets and risk exposures are. Here to discuss one fund in particular that we recently downgraded is Gretchen Rupp. She covers multi-asset and alternative strategies on our manager research team.

Gretchen, thanks for being here.

Gretchen Rupp: Nice to be here.

Wallace: I wanted to start by discussing a fund that you recently downgraded from Neutral to Negative. What went on there, and what were the reasons for the downgrade?

Rupp: LJM Preservation and Growth sold put and call options on S&P 500 futures. It's in our options-based category. The fund lost 55% on Monday, Feb. 5, after the volatility index, the VIX, spiked a large amount in one day about 20 points. It's not the highest the Volatility Index has ever reached, but it was a large spike. What that does is the options in the fund, the value of them changes drastically when volatility picks up like that. As a result, the value of the fund drops severely. They likely had a margin call that evening which contributed to a second-day loss of 56% when the managers essentially liquidated out of all of their put and call options. Combined, the loss was a total of about 82% over a two-day period which is extremely severe for a mutual fund.

Wallace: That precipitated the downgrade in addition to other ...?

Rupp: Correct. We downgraded it to Negative, not only because of the loss in fund holder value, but also because of the lack of oversight on the part of the fund company, not to strike an NAV the following day. Investors were unaware of what the fund lost on Monday until late in the day on Tuesday. It's just a complete failure on their part of their risk management process.

Wallace: What would be the appeal of a fund like this in the first place? Why would investors want to invest in a fund like this?

Rupp: Sometimes investors look to options-based funds because they hold low correlation to equities and fixed income. The right options-based fund can behave like an allocation fund in that its risk and return profile, it might return less than the S&P 500, but it carries less risk or standard deviation, which is one measure of risk. The options inherent in the fund don't carry the same risks as fixed income. There is no interest-rate risk, for example. However, you can't look solely at its correlation with the markets or with fixed income, or you can end up with a situation like LJM where you lose a large amount in one day. The correlation matters but it's not the only thing that matters when it comes to looking for an options-based fund.

Wallace: You also can't solely pay attention to a fund's name?

Rupp: Correct. This fund actually had preservation in its name which obviously investors cannot rely upon in this case.

Wallace: In a larger context, should investors avoid all option-based funds? Are they all as risky as this one is?

Rupp: No. The options-based category has about 75 funds, and they are not all uncovered puts and calls like LJM Preservation and Growth. The majority of the assets are held in funds which are covered call strategies. The actual underlying stock is also owned with the fund. A covered call strategy would own the stock and then they sell a call option on the stock, which generates premium, and it limits the upside potential, but the additional premium adds additional yield. Sometimes those funds will buy downside protection in the form of portfolio insurance with that premium, so they can also buffer some of their downside losses. What that results in is a range-bound scenario for the fund. That is the most common strategy in the options-based category.

Wallace: What are some funds that we like that employ an options-based strategy?

Rupp: The largest fund in the category has more than a 40-year track record. It's Gateway. We rate it Silver. We actually nominated it for the Manager of the Year in 2017. It's had very predictable returns. They own the underlying in securities to track the S&P 500, and they write at the money call options on those securities. Then they take some of that premium generated from the call options that they sell, and they buy additional portfolio insurance to protect against large downside moves in the market.

Wallace: Not a high volatility strategy?

Rupp: No. A very different strategy from LJM Preservation and Growth. There aren't as many funds in this category with long track records. Only five have a track record since the 2008 financial crisis. It's very important that investors know what they own and why then own it and know that the track record is there to prove what the strategy is claiming it can do in the future.

Wallace: Great. That's great advice. Thanks so much for being here to discuss this, Gretchen.

Rupp: Thank you.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.