Hedged equity brings defensive strategy to volatile markets

Defence may be the new offense in today’s volatile markets. Investors reeling from losses in nearly every asset class are actively seeking new strategies for managing downside risk, without sacrificing upside potential. Investors looking to protect their portfolios from free-fall – but still maintain some equity exposure – have not had an abundance of choices. Products that specialise in managing downside risk tend to underperform in strong bull markets, and may not receive much attention under normal market conditions. But in a market that has savaged both growth and equity styles, even traditional long/short strategies have generally failed to live up to expectations. As a result, demand has been high for a strategy that can flourish in volatile times. That helps explain the growing interest in Gateway Investment Advisers LLC, a firm with decades of experience running hedged equity strategies. Gateway, an affiliate of Natixis Global Asset Management, has long practised a strategy that may be ideal for times such as these, when volatility remains consistently high. While investors may have new reasons for considering hedged equity, the Gateway strategy is not new. It has been tried and tested for over 30 years and has attracted more than $7bn (E5.38bn) in assets under management¹.Gateway’s risk-conscious approach to equity investing seeks equity-like returns with a lower risk profile. The strategy remains consistent, regardless of market conditions, but it tends to perform best when volatility is high. Hedged equity is a relatively simple idea but one which demands professional investment expertise. The Gateway strategy is unique in that hedging is applied to the whole portfolio, rather than to individual stocks, and it involves absolutely no fundamental stock-picking. The foundation of the portfolio is a diversified basket of stocks chosen to emulate a broad market index. Once this initial portfolio is in place, the hedging part of the strategy can begin. Two-part hedging strategy The hedging strategy consists of two elements. First, the portfolio manager constantly sells index call options on the chosen index. Call options give the purchaser of those options the opportunity (but not the obligation) to buy exposure to the index at a certain pre-determined price, at an agreed future date. That means the buyer is paying for the right to any appreciation between the pre-determined price and the realised value of the index on the agreed future date, recognising that the call option will be worthless if the realized value of the index is below the exercise price at expiration. The portfolio creates an ongoing cash flow from the sale of these options, which adds to relative return whenever the market is flat, down, or up less than the cash received. The flip side is that it limits upside potential – the level of participation in any rise in the stock index. The call option component of the strategy tends to contribute positively to performance in flat or fluctuating stock markets, and less well in a strong upward market, though even then it can mitigate risk in the portfolio. The second component of the strategy involves buying index put options. Put options give the buyer the right (but again, not the obligation) to sell the index at a certain time for a certain agreed-upon price (the strike price). The purchase price of index put options — generally set at around 6-10 per cent below the current market level — helps limit the downside risk for investors in the event that the market takes a short sharp dive, as has happened so often recently. Of course, the cost of the put options will reduce the total return if the market does not fall. The strategy is generally 100 per cent covered with the sale of call options, but not always completely covered with the purchase of put options, as much depends on the price of the options available in the market. The selling price of index call options depends on the perceived volatility in the market place. The market volatility that increases the premium managers can earn selling call options also raises the cost of defensive puts. The key to the success of Gateway’s strategy is the cash flow earned by the sale of the call options, combined with the protection offered by the put options. With these mechanisms in place, the portfolio achieves a unique balance between risk and return. Most important in today’s markets, the strategy seeks to leverage daily volatility, and ultimately views this approach as a lower risk way of participating in equity markets than direct exposure to share price movements. The strategy has historically helped preserve capital during periods of heightened market volatility. Available to European investors Gateway’s hedged equity approach is already popular among institutional and retail investors in the US, and is now available to some European investors in the form of two Luxembourg-domiciled funds managed by Gateway². Both funds use the same strategy, but on different underlying portfolios. The Gateway U.S. Equities Fund portfolio is very similar to that of the Gateway Fund (available in the US) which has been managed by Gateway Investment Advisers since December 1977. The underlying equity portfolio is constructed to track the performance of the S&P 500 Index, but with fewer stocks. The Gateway Euro Equities Fund has an underlying equity portfolio that virtually matches the Dow Jones Euro STOXX 50 index. Gateway’s risk managed approach is attractive to three general types of investors. Risk-averse investors, a group whose ranks have swelled in recent months, generally need some growth potential but are concerned about market volatility. For these investors, hedged equity offers the chance of steady growth with limited downside risk, through equity market participation in a portfolio that has historically exhibited bond-like volatility. A second group includes income-oriented individuals who are just starting to draw on savings. For them, hedged equity offers the possibility of some growth while not fully exposing their money to the risk of the market. The strategy also offers valuable diversification, with volatility levels comparable to those of intermediate- to long-term fixed income investments, but with actual correlation to bonds effectively zero. For that reason many investors may choose to invest a portion of their fixed income portfolio in hedged equity. A third group attracted to hedged equity are investors who are looking for an alternative investment strategy, but who do not qualify for a hedge fund. For them, hedged equity may provide a convenient alternative to hedge against dramatic downside risk over a short period of time, with the emphasis on risk-adjusted returns, and the liquidity and transparency of a mutual fund. In this year’s extreme market environment, many more investors may fall into one of these categories. For these investors, hedged equity presents a unique investment proposition. It is well suited to periods of volatility and may be a good match for investors whose needs are not entirely or satisfactorily met by existing asset classes and long/short strategies. Its risk-managed approach may allow investors to maintain exposure to the recovery potential of the equity markets, with considerably lower downside risk than traditional equity investments. Michael T. Buckius, CFA, Senior Vice President, Gateway Investment Advisers LLC ¹ As of 31 December 2008.

² These funds are sub-funds of Natixis International Funds (Lux) I which is organized as an investment company with variable capital under the laws of the Grand Duchy of Luxembourg and is authorised by the financial regulator (the CSSF) as a UCITS. The funds have also been authorised for sale to the public in certain other European jurisdictions including the United Kingdom