Markets & Finance

The Gateway Fund's Hedging Edge

It looks like an equity fund, thinks like a hedge fund, and acts like a bond fund. Established in December, 1977, Gateway Trust:Gateway Fund (GATEX) calls itself a "risk-adjusted equity mutual fund." By prospectus, it strives for equity-like results, but a bond-like risk profile.

J. Patrick Rogers, who has run the fund since November, 1994, relies on hedging techniques. "There's no fundamental analysis," he says of the portfolio. "The security selection strictly tries to be efficient in getting market exposure with a similar total return to the S&P 500 [stock index]." The

hedging strategy does the rest.

LIGHTENED UP. In September, 2004, the fund changed its investment objective and strategy. Rather than purchase every stock in the S&P 500 as it previously had done, it now seeks to own fewer stocks and to approximate the index' price movements while holding a higher proportion of dividend-yielding issues.

Of the fund's 310 holdings as of Mar. 31, 180 issues were equities in the S&P 500, 120 were "non-S&P holdings" (largely

put and

call options), and 22 were American depositary receipts. Total assets are about $2.3 billion.

For the three-year period ended Mar. 31, the fund posted an annualized return of 4.1%, compared to a gain of 1.8% for the average large-cap blend fund, and 2.7% for the S&P 500. The results were achieved with nearly half as much volatility. For the 12 months ended in March, it rose 6.4%, vs. a gain of 5.6% for its peers, and 6.7% for the S&P index.

Though Standard & Poor's categorizes the portfolio as a large-cap blend fund, it doesn't have a stated benchmark. Based on risk-and-return characteristics over the last three years, Standard & Poor's gives Gateway Fund its highest rank of 5 Stars.

Carol A. Wood of Standard & Poor's Fund Advisor spoke recently with Rogers about his investing strategy. Here are edited excerpts of their conversation:

Q: How would you describe your investment philosophy?

A: We don't select equities based on "buy and hope," or because we think they're going to outperform the market. We pick securities to get a representation similar to the S&P 500, with a similar price movement. That supports our options strategy.



It's exactly the same thing we're doing with our option strategy. We have a portfolio of stocks we want to own for a long time. We're hoping for some appreciation but are mainly interested in using that asset to generate cash flow.

The cash flow comes through the continuous sale of index call options on the S&P 500. We mix up the expirations and pricing of the options to make sure we're getting maximum value. That activity typically brings in about 18% to 20% in annualized cash flow. We've seen it as low as 10% annualized and as high as 40% annualized. We're fully hedging our portfolio.


A: That's why it's important that the stocks we have in the portfolio move in a similar manner to the S&P 500, so that we have a nice match with the index-option side, so that they will move in relation to one another.


Index options are totally different from individual options. They only settle in cash. There's a continuous market, and we know on a minute-by-minute basis what each option is worth.


Q: You might in some cases have to fork over some cash.


Q: Does that happen very often?

A: No, because the market would have to rise pretty dramatically. One of the beauties of our strategy is that when we need to raise cash, it's at a time when the market has done extremely well. So essentially, it forces us to sell securities after a big run-up.

Let's say Microsoft goes down to $20. I still own Microsoft and feel that move -- but am able to keep your $5 premium. I'm now sitting with excess cash, so it forces me to buy stocks after the market has fallen. We're fully invested. So it's a nice little discipline imposed in the strategy.


Q: Who buys your call options?

A: Individual investors who are speculating, hedge funds who are using options to offset some of their risk, and institutional investors and dealers on Wall Street trying to offset the risk on their own books.



We don't like to expose the portfolio to all that pain because our fund is very conservative. We're trying to earn rates of return normally found in other conservative asset classes, like fixed income. So we use some of the cash flow to buy downside protection in the form of index put options. A put option gives you the right to sell your securities at a certain price over a certain period of time. So it's like owning an insurance policy with a deductible.

We're not so concerned about a moderate decline in the market because we've got cash flow coming in to offset that. What we're concerned about is a major decline in the market in a short period of time. The put options that we buy are between 8% to 10% below the market, so we're essentially buying insurance policies with an 8% to 10% deductible.

Q: That limits your loss to that amount.


So, when you wrap all this together, you're left with a potential performance profile that's pretty limited. We're certainly not going to hit any home runs if the market's doing well because we've sold off that upside. The most that we can earn is essentially the net cash flow, the net premium from selling the index calls vs. what we're paying for the downside protection. That typically has been about 12% per year.

We've seen it as low on a net basis as 5% to 6% about 10 years ago. Last year, like this year, that premium is lower than normal, so we're looking at returns of 7% or 8%. But we've also seen it as high as 20%, right after the crash of 1987, in 1988-89.

Q: Does the movement of your fund follow the bond bull market?

A: No, and that's why it's such a great asset-allocation diversifier. Our raw volatility is going to be similar to what you would find in an intermediate- to longer-term fixed income fund. But there's no correlation to fixed income. As a matter of fact, we like higher interest rates because they're one of the pricing components in options.

When the bond market is doing very well, we're going to have our substandard quarters. And when the bond market has typically done poorly, we have done well.


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