Like a lot of alternative investment strategies, the $4.3 billion Gateway Fund (GATEX) thrives on the kind of stock market volatility we've been experiencing lately.
In the more than 30 years since the fund was created it has seen its share of market cycles. Not all have been kind to Gateway, which tends to lag its benchmark in raging bull markets.
But there is little doubt the fund's modified long-short equity investing strategy has been taking advantage of current market conditions. In 2007 the fund gained 7.9%, while the Standard & Poor's 500 Index finished the year up 5.4%. Through the first quarter, the fund was down 3%, while the index was down 9.4%.
Beyond that, however, you have to go back to 2002 to find a calendar year in which the fund outperformed its benchmark.
"This fund is going to look best in tough times, which is why it should make money in the current market," said Greg Carlson, a mutual fund analyst with Morningstar Inc. in Chicago.
"It provides solid equity exposure for conservative investors, but it will rarely break into double-digit returns," he added. "And it will rarely beat the S&P 500 in an up year."
The fund did generate double-digit returns in both 2003 (up 11.6%) and 2006 (up 10.1%), but it lagged the S&P, which gained 28.7% and 15.8% in those respective years.
The fund's performance, compared with Morningstar's long-short equity category, is less significant because the strategy is unique, according to Mr. Carlson. This also helps explain the fund's respectable, but not spectacular, three-star rating, he added.
However, the fund did outperform its Morningstar category average during the first quarter of 2008, as well as during the last two calendar years. Beyond that, its performance essentially matched the average performance of the category in 2004 and 2005.
"I don't know of another mutual fund that does exactly what this fund does," Mr. Carlson said. "It's definitely a unique strategy."
FUND STRATEGY
The basic investment strategy is made up of three main moving parts.
Lead manager J. Patrick Rogers and co-manager Paul Stewart begin by building a long position in a basket of about 325 stocks designed to perform like the S&P 500. This basket of stocks, which tilt toward companies that pay relatively high dividends, can include companies outside the S&P 500 as well as those that issue American depository receipts.
There usually are 15 to 20 ADRs in the portfolio, according to Mr. Stewart.
"In order for the strategy to work the portfolio needs to perform like the S&P, which it does," he said. "But we're trying to replicate the index in a cost-efficient manner," which is why they don't just use an S&P index for the base of the portfolio.
As a portfolio manager, Mr. Stewart views the fund the way a real estate investor might look at an apartment building.
The index replication corresponds to the value of the apartment building. Corresponding to the rental income generated by tenants, the fund sells S&P 500 Index call options against the underlying portfolio. This is the short side of the long-short strategy.
The third part of the strategy involves put options. Analogous to an apartment building's property insurance, the fund buys index put options to guard against a steady or dramatic market downturn.
Gateway, which was created in December 1977, has been doing this since 1988, when it modified its investment strategy to permit use of the then-new options product.
One of the reasons the strategy makes sense now is that it thrives on market volatility, which is currently measured at more than double what it was in January 2007.
"The biggest driver of our return is the volatility that's reflected in the options pricing," Mr. Stewart said. "We like to think of the fund as a core holding regardless of the market, but there's no doubt that volatility helps us."
There is also a tax-efficiency component due to the fact that the stocks in the underlying portfolio that mimic the S&P 500 have an average annual turnover rate of less than 15%.
The portfolio's cash position is in $100 million range, which is necessary to help reduce the liability related to option calls, according to Mr. Stewart.
Questions? Observations? Stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews com.
