The fund:

Managers:

The call:

On February 12th we spoke for an hour with Alan Salzbank and Josh Parker, both of the Gargoyle Group, and Morty Schaja, CEO of RiverPark Funds. Here’s a brief recap of the highlights:

Alan handles the long portfolio. Josh, a securities lawyer by training, handles the options portfolio. He’s also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They have 35 and 25 years of experience, respectively, and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Morty has been investigating buy-write strategies since the mid-1980s and he described the Gargoyle guys as “the team I’ve been looking for for 25 years.”

The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month.

The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (P/B, P/E, P/CF, P/S) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the 100 more undervalued stocks, but maintain sector weightings that are close to the S&P 500’s.

The options portfolio is a collection of index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums.

Why index calls? Two reasons: (1) they are systematically mispriced, and so they always generate more profit than they theoretically should. In particular, they are overpriced by about 35 basis points/month 88% of the time. For sellers, that means something like a 35 bps free lunch. And (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their upside.

And it works. Their long portfolio has outperformed the S&P 500 by an average of 5% per year for 15 years. The entire strategy has outperformed the S&P in the long-term and has matched its returns, with less volatility, in the shorter term. Throughout, it has sort of clubbed its actively-managed long-short peers. It also anticipates clubbing the emerging bevy of buy-write ETFs.

The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month.

There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000-12, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P.

Except not so much in 2008. The fund’s maximum drawdown was 48%, between 10/07 and 03/08. The guys attributed that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback comes in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%.

The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble.

In general, the strategy fares poorest when the market has wild swings. It fares best in gently rising markets, since both the long and options portfolios can make money if the market rises but less than the strike price of the options – they can earn 2% a month on an option that’s triggered if the market rises by more than 1%. If the market rises but by less than 1%, they pay out nothing, pocket the 2% and pocket the capital appreciation from their long portfolio.

What’s the role of the fund in a portfolio? They view it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. For the guys, it’s 100% of their US equity exposure.

The conference call

The profile:

On average and over time, a value-oriented portfolio works. It outperforms growth-oriented portfolios and generally does so with lower volatility. On average and over time, an options overlay works and an actively-managed one works better. It generates substantial income and effectively buffers market volatility with modest loss of upside potential. There will always be periods, such as the rapidly rising market of the past several years, where their performance is merely solid rather than spectacular. That said, Messrs. Parker and Salzbank have been doing this and doing this well for decades.

The Mutual Fund Observer profile of RGHVX, September, 2015.

Web:

TCW/Gargoyle Hedged Value homepage. 

Fund Focus: Resources from other trusted sources