Market Commentary as of 3/31/08
The one word that epitomized the first quarter of 2008 was 'volatility'. During the last three months the US equity market, as judged by the movements of the S&P 500 Index, gyrated up and down in as frenetic a manner as one could imagine. As emotionally uncomfortable as these fluctuations were, the Fund managed to weather the storm quite well relative to the benchmark since its mid-January inception.
Stocks and Calls
We manage the Fund from two perspectives—as an equity portfolio and as a cash flow generator—both of which contributed to its outperformance. By focusing on larger, mostly dividend-paying companies, we were able to sidestep the first quarter decline relative to the market. A dividend-yield of almost one percentage point greater than the S&P 500 helped to mitigate downside volatility as well, with the exception of Financials, which was our worst performing sector.
The Fund sold call options on virtually the entire portfolio of equity holdings, which collectively generated a cash flow equal to 4.5% of the total common stock investments. In a number of instances, particularly with regard to Financials, we repurchased some of the call options at a profit and subsequently sold others to generate additional cash flow. While that strategy of rolling the calls by itself accounted for only a fraction of the excess return, it provided a helpful boost on the margins.
By the end of the quarter, the Fund's accumulated options cash flow equaled 4.6% of the portfolio and 95% of those options will expire by the middle of October of this year. Therefore, if the underlying portfolio remains static for the next six months virtually all those options will expire worthless—allowing us to retain most of this income (90% of the stocks are currently below the strike price of the options). While we recognize this is a theoretical calculation, it is illustrative of the cash flow that selling calls can generate on an equity portfolio.
Big Picture
Although we do not manage the portfolio from a top-down perspective, we are cognizant of the macroeconomic environment and do have an opinion as to how events could unfold and affect the Fund's holdings. In that regard, it is quite clear that the US economy has slowed markedly during the past several months. While the debate as to whether or not we have entered into a recession rages on in the financial press, to us the more important point is that the economy has already slowed dramatically during the last two quarters. What the rate of change in economic activity in this country will be and whether the US slowdown will spread to the rest of the globe remain the key questions.
In our opinion, the leading engines of consumption in the world—the US, Europe and Japan—have all begun to slow, which in turn will impact the major producers of goods and services like China and India. Clearly, many of the industrial commodities are beginning to reflect this potential change, and the equity markets in the developing countries are amplifying this as well. At the same time, our central bank is injecting a massive amount of financial stimulus that will ultimately help to resolve the current liquidity crisis. In our opinion, the actions by Congress and the Federal Reserve Board have sown the seeds of recovery, though it will take time to work through the system.
Moving Further Out of the Money
Given the virtual implosion of valuations within the Financial and Consumer Discretionary sectors as well as the government intervention mentioned above, we believe the environment is conducive for these sectors to outperform the market over time. Although slim earnings (or the lack thereof) could persist for a few more quarters, we believe the equity market is a discounting mechanism that will anticipate the eventual recovery well before it actually occurs. By this time next year, we expect the year-over-year growth comparison will be quite positive given current valuations.
With this in mind, we have tweaked our option strategy for the present moment. Instead of selling calls 6% out-of-the-money, we are now writing calls 10% to 20% out-of-the-money. Interestingly, the Fund is able to do this without having to sacrifice premiums. Because of the increased volatility, the same cash flow is attainable at a much higher strike price. Consequently, if the equity market does rally in anticipation of easier comparisons later this year or early next year, the Fund will be able to participate.
Should events not transpire as we anticipate, however, we believe the overall portfolio has enough diversification and exposure to large-cap value equities to make us feel comfortable on a long-term basis. Additionally, cash flow from options and dividends should be beneficial in the near-term under either a positive or a negative scenario. The one outcome that could overwhelm our positioning would be a precipitous drop from this point in the US equity market. Given the steps taken by the Fed and Congress up to this point, and the undervaluation of equities versus fixed-income securities on a historical basis, we view such a scenario as a low probability.
Ron Altman
Portfolio Manager
Paul Pfeiffer
Co-Portfolio Manager
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned. Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.