Defensive by nature: Gateway low-volatility equity strategies

Chuck: Welcome to the Big Interview on the April 17th edition of Money Life. Joining me now, Joe Ferrara. He is investment strategist at Gateway Investment Advisers. It's a Natixis Investment Managers company. So if you want to learn about Gateway, it's gia.com. You want to learn about the parent company Natixis, go to im.natixis.com. Joe Ferrara. It's great to have you back on Money Life.

Joe: Thanks, Chuck. Thanks for having me.

Chuck: You know, at Gateway, I don't need to tell you this, but I need to tell my audience. You guys tend to be a bit defensive by nature. You are using strategies that tend to be a little defensive by nature. And right about now, everybody wants to play defense. But is this a great time to be playing defense or when everybody is a little freaked out? What does that do in terms of your market outlook?

Joe: Sure. You know, so just to be clear, you're spot on. Yeah. We at gateway manage what we would call low volatility equity strategies. Our goal really is to smooth out the ride of owning equities for our investors. You know to the defense point it's interesting. These are the times in market cycles where Gateway becomes more in vogue, if you will. People reach out whether they're existing clients or prospect clients asking – hey are your strategies doing what you've told me they're supposed to do? Or, you know, kind of as expected? And we would say resoundingly, yes, in this current market environment. But largely our strategies, we believe that we're really experts on the derivatives side, trading side. And what we seek to do is monetize volatility. So in particular, when the market falls, whether it's a known or an unknown kind of action item, if you will, or, you know, obviously we know a lot of items coming out of the administration currently. It's our job to take what the market gives us and smooth out that right of owning equities. So that's really where and how we're functioning right now. And you know, to your question about should everybody be owning the defense right now or look to a defensive strategy? We would most likely say, yes. You know, again, at Gateway, we believe our expertise is on the derivative side. On the equity portfolio side, we're typically passive, quantitatively driven largely because we believe it's very difficult to add value long term as a bottom-up fundamental stock picking portfolio or really kind of any other selection criteria. So we choose to be passive on that side, and active on a derivative side. And the result has been really healthy for us so far this year.

Chuck: You talked about volatility in there and foreseeable volatility and also unforeseeable volatility. But the volatility we're getting right now is magnitudes beyond normal at least to this point. Is this volatility where you might wind up with a week or a month's worth of movement in a day. Is that now becoming normal? Why should we expect that to continue until at least there's some clarity over a tariff policy in the rest?

Joe: Sure, sure. You know, volatility is an interesting, quantifiable statistic for us. You know, obviously it's the VIX benchmark is the kind of the CBO volatility index or the VIX benchmark is what most people use long term average. That benchmark goes back to about 1990. The long-term average is around 19.5 on that benchmark. We believe that there's still a very real recency bias for a lot of investors. And the recency bias is quantitative easing. When we saw very low and kind of stale measures of volatility, you know, measures of the VIX largely because we had, fed policy that was very accommodative for a number of different things, but certainly for growth investing. And we had a market that was really doing nothing but going up. Right. I mean it was just such an interesting time to be an investor. Covid happened. Obviously, we saw massive spikes in volatility, massive drawdowns in the market, but it was quantifiable. We could understand what was kind of happening and going on, what we're seeing now.

And then just to kind of to put some perspective around it. You know, we saw a spike in the VIX up over 60 the other day when Trump and the administration first really announced the plan for tariffs. And in these trade wars, if you will, the volatility index has since come back into about a 30 or 31 level right now. But what's really interesting for us is, we saw market dynamics that were comparable to the global financial crisis a little bit, but almost more so to 9/11. Which we thought was really interesting because obviously that was a terrorist attack. And, you know, every other dynamic that went along with it. The stock exchanges were talking about closing down for, you know, days if not weeks to try to understand what was going on in the world. Picture, what we have today is quantifiable and not quantifiable, right? We know in the moment what happened, what the announcement was, and we can kind of measure the potential outcomes. What we don't know is that kind of future, right. And that not easily quantifiable aspect, which again, we believe makes the case for owning a low volatility equity strategy, like what Gateway manages.

Chuck: As we were trying to arrange to get you back on the show, I had been looking through commentaries from Gateway, and I'm curious how some of the thought perspectives influence the investment side of things, because before everyone was talking about tariffs, because we knew that President Trump was going to do them. But back in February, you guys were raising some concerns about, you know, okay, if we're going to have tariffs, the idea is to have to generate enough revenue to offset tax cuts and or to help pay the bills, like to bring in money that we can use with the federal debt. And you were worried about the debt and interest expenses, etc.. How concerned are you now about just the policies, and whether or not they can achieve their goals? And then secondarily, how does that influence positioning? Because volatility is one thing that you can watch. And measure, but you still have this hunch of this is where we think it's going to be and how we think it's going to work out. So how much does the thinking part the oh, we're watching this and I do or I don't like this influence. This is what the numbers are telling us to do and think.

Joe: Yeah, a good question. There’s a lot to that question. Obviously, I said it kind of briefly to start. Yeah. We at Gateway are not trying to make market calls, or trying to predict Fed policy. Certainly not making individual stock selection decisions. Rather we’re passive on the equity side and active on the derivative side. So you know, our market perspectives, which we post monthly up on a, roughly monthly, up on our website and through your representative at Natixis, what we try to do there is, is uncover or at least talk about and bring to light some of the interesting market dynamics that pertain to our strategies. And you hit the nail on the head. The things that we're noticing the most lately are these dynamics with interest rate policy, these dynamics with volatility. And then most importantly, how it affects equity investing. And even though we would say fixed income investing because, yeah, if you look at our Gateway Fund, for example, our flagship strategy has been around for an over 40 years now. That's our low volatility equity strategy. And on a risk adjusted basis, you could even put that up against some fixed income allocations. Comparing and contrasting the two. It can provide balance. It can provide stability to an equity portfolio or to an overall asset allocation. We would say, you know, largely, what do you think about the Gateway Fund? It's passive. On the equity side, we are 100% notionally written on a call side. On the portfolios, we only trade an S&P 500 index-based options. We typically target a 50-delta profile for the overall portfolio, which leads us to be trading, and equity call options that are roughly at-the-money right now. Because what that does is it allows us to generate the most amount of premium, really, for the least amount of risk in the portfolio. We're not trying to add risk to the portfolio. We're not adding leverage. We're not kind of doing anything funny with that cash flow. That cash flow is meant to go into the portfolio, provide ballast, provide stability. We also purchase a portfolio of puts in the portfolio, S&P 500 index-based options, again, that are typically somewhere between 8 and 10% out-of-the-money. So that allows us again to provide some ballast, some protection to the portfolio should the market take a large downturn, should volatility really spike, we're able to monetize those positions and again provide a lot of protection for our investors. 

Our newest product we've been we launched an ETF for about a year and a half ago. It's the Natixis Gateway Quality Income ETF. Ticker is GQI. That portfolio has a high-quality screening criteria on the equity side with a derivative program, a call-rating program on roughly half of the portfolio. But what's different with this product is we distribute that income. And that portfolio has a really nice zig and zag aspect, we would say. So, for example, we know that that quality factor can perform on the upside, but also should provide some protection on the downside. Large multi-year organizations, companies that have strong and growing balance sheets and cash positions, for example. And we couple that with that derivative program for income. So in this market environment right now, for example, as the portfolio of equities was trending downward with the market and with that quality factor, the yield component actually increased pretty healthy.

You know, we're almost at, I think, around 12% with an SEC yield in that portfolio right now. And that's distribution-able income. So clients that may be in the distribution phase of their investment life cycle have the ability to not really have again, there's no guarantees in this market, but you're going to continue to receive that consistent income. So if you have bills to pay, if you have a mortgage to pay, you still have that income and you can hopefully sleep a little bit better knowing that the equity portfolio is still intact. And we hope that it will continue to on its, trend upward, if you will. 

Chuck: There has been an evolution in the investment world, especially on the ETF side, with a whole bunch of options-based strategies coming in and becoming sort of very much pitched for average investors who don't necessarily wake up in the morning and go, oh, wait, hold that. I need an options income sort of strategy or what have you. Gateway's been doing this for a long time. Like the Cboe started trading modern options contracts in the 1970s. And you guys were there basically from the beginning. But as you're watching the proliferation of the strategies, how important is it that investors understand that the differences between options strategy are not the same as like, oh, I own a large cap values fund versus a large cap blend fund, etc. that that option strategies are wildly or can be wildly different. And just because you like what you hear about one, don't like go, oh, that's an option strategy. It's the same.

Joe: Yeah, you hit the nail on the head with that one, Chuck. So a few things right to that question. And some of those statements. You're spot on. Gateway's been doing this for over 40 years. We were around before, you know, really, index-based options were even a or even a tradable asset. So certainly have experience. And we think it benefits us and our investors significantly to have that experience under our belts. Kind of the crux, if you will, of your question and your statements. There is knowing what you own. Right. We see a lot of investors that buy mutual funds or ETFs or what have you, and across asset classes that aren't really confident or sure what the manager is doing and what they actually own. So for our ETF, for example, again, the ticker GQI, we have that high quality factor focus on the equity side. And we have a derivative program S&P 500 index-based options only. We're not adding risk to the portfolio or leverage to generate that income. There are a number of competitive products out there that are just index-based funds charging a pretty healthy fee, you know, for what they do. There are others that have different tilts. Again, we have a high-quality factor focus. There are others that are defensive or min-vol. Some of them are based on the Nasdaq index. So, you know, we would argue that that's a tech bet or a tech kind of, you know, component to your portfolio. But largely I think it was Blackrock that wrote a report just a week or so ago that analyzed this income-producing equity space. And in particular, on the ETF side, the market's roughly, you know, 100 billion or so right now. And they anticipate that to grow two, if not three-fold in a matter of maybe five years or so. So it's a really large and massive opportunity in the space. And then I think investors also need to understand the income side of their portfolios, because it can be treated as return of capital, and there are tax consequences there. It can be treated as ordinary income compared to dividends that may not be. So investors really need to, we think, seek and understand the information and know what they own. In particular, if they're not trying to add risk to their portfolios in a market like we're in right now, I would be remiss if I didn't ask you about interest rates.

Chuck: And specifically, have you got an outlook on what the Fed might do and what it means if the Fed keeps interest rates a little bit higher for a little bit longer, waiting for some direction on unemployment versus inflation?

Joe: To the latter part of your question, we would welcome that higher interest rates for a longer period of time. It would benefit option premiums. We at Gateway as a seller of those premiums trying to monetize those premiums, our investors would benefit from that. More specifically to your question about kind of a Fed policy, if you will. You know, we are Gateway, again, don't try to predict or crystal ball any of those types of movements really. What we would say though is we firmly believe that we're kind of where we are today. Roughly 4.5% from a fed funds standpoint is really healthy, and we would say very normal level. If you go back and study, for example, the three-month t-bill over the last 40, 50 years, the long-term average is around 4.5%. Again, that recency bias of quantitative easing, when we had a decade or so of close to zero as we could get, is still very real for investors. And in particular, you talk about inflation and we talk about the, you know, these policies that the administration is putting in place. That's a very real component to investors. You know, you look at some of the other research reports that have been published recently about the number of Americans that are even invested in the stock market. For me, it was drastically lower than I had anticipated. You know, there are reports that read anywhere between kind of 25 and 40% of Americans are actually invested in the stock market. So that leaves a significant number of people, of Americans, we would say, that aren't. However, they're being significantly impacted potentially by inflation and the price of everything kind of going up right now. So, you know, those components are what will most likely play into the Fed policy. And we know this Fed is very data driven right now. All of that being said, you know, bringing it back to you, kind of what we try to do for our investors. Interest rates that are higher and stable for longer would will benefit our investors by allowing us to generate more cash flow. And in the Gateway Fund, for example, that cash flow goes back into the portfolio, into the Nav provides stability and ballast in challenge markets. And then for GCS, our ETF, those premiums will be distributed out to our clients.

Chuck: Joe great stuff. I appreciate you taking the time out to join me. We'll talk to you again as we watch it all play out.

Joe: Great. Thanks, Chuck. Nice seeing you.