Gargoyle Hedge Funds Play Their Options

Apr 26 2013 | 11:44am ET

To understand its approach to investment, Gargoyle Group co-founder and investment strategies head Joshua Parker says you need to know three things.

First, options are the "perfect" hedge.

“I want to put 'perfect' in quotes,” Parker told FINalternatives. “If I sell an index call option and the index drops by expiration, I am 100% guaranteed to make a profit on that short call. But if the market were to rise, I might still make money on that short call, if the market doesn't rise through the strike price by the amount of the premium.”

Second, major-market U.S. index options are “systematically over-priced.”

“They're overpriced on average over 85% of the time over the last 25 years,” says Parker, “By the way, this is the worst-kept secret in options trading. You can go to the Chicago Board Options Exchange Web site and see a number of different charts and studies showing this. And they're over-priced by over 35 basis points per month.”

Third, to use this "perfect" hedge you must dynamically manage your options portfolio.

“Because of the characteristics of options, as the market moves and as time elapses, a position can become 100% long or 100% short. If your goal is to use these options to hedge your underlying equity risk, you can't just put on a position and walk away. You don't want to say to your friends, 'Hey, I was hedged on the third Friday of April but I wasn't hedged any other day during that month.' That's the third thing which differentiates Gargoyle—our constant-hedge approach.”

The Bridge Connection

Before Parker was a hedge fund manager, he was a lawyer—and a national bridge champion. It was a fellow bridge champion, Michael Becker, who recruited him into the options world and onto the floor of the American Stock Exchange in 1986.

Englewood, N.J.-based Gargoyle was founded in 1988 as an option market maker on the AMEX floor. It evolved into a multi-trader operation and, in 1998, bought an options specialist book and moved off the floor. The first hedge fund was launched in 1997, but for the first three years the firm actually sold individual stock options, a strategy that changed in 2000 when it began selling index options. Today the firm, one of the leading private options firms in the United States with about $600 million under management or advisement, has almost 30 employees—including a dozen investment professionals.

But it all started with bridge, and Parker says that's no coincidence.

“There's a lot of money managers out there who play bridge, or poker or backgammon,” says Parker. “The person who sponsored me on the floor, Mike Becker, is a Hall of Fame bridge player, former world champion. He came down to the floor in the late '70s, and he said, 'You know, the exact same skills that make a good bridge player—money management, comfort with math, comfort with risk, calculating odds on your feet—make a good options trader.”

So should all would-be money managers play bridge?

“Yes,” laughs Parker, “everybody should be a bridge player. Warren Buffet, by the way, is a big bridge player as is Bill Gates. Not that Bill Gates is a money manager but as I recall he's done pretty well for himself.”

The Funds

Gargoyle's hedge funds—it also runs a mutual fund and a customized institutional options overlay service—are relative-value quantitative funds, with a diversified portfolios of mid- to large-cap U.S. stocks. To select those names, the firm uses a quantitative methodology that weighs a number of ratios, including price-to-book, price-to-earnings, price-to-sales and price-to-free cash flow.

“The secret sauce is how we weight those,” says Parker. “We also have some secondary factors as well as a few subjective overrides. We've now been doing this scoring methodology for 13 years. Our stocks, on average, have outperformed the Standard & Poor's 500 Index by almost 500 basis points a year.”  He says the more aggressive Gargoyle Enhanced Alpha Fund, launched 15 months ago, has outperformed the S&P500 by something closer to 800 bps per year, albeit with more volatility.

Once the stocks have been selected, Parker says the goal is to hedge them in a way that exploits the over-priced nature of index options. The firm runs a series of correlation analyses to determine the basket of indices that best correlates to the portfolio of stocks, and then sells index calls on the indices in the basket.

“We get between 400 and 500 bps of alpha on the stock side by virtue of our relative-value purchase and we get another 400 to 500 bps—by the way, all these numbers are gross—on the options side by virtue of picking the right basket of indexes that hedges the stock portfolio,” says Parker.

The new fund targets a 0% long exposure, where the flagship Gargoyle Hedge Value Fund targets 50% long.

Gargoyle's flagship Hedged Value Fund has about $150 million in assets, while the newer Enhanced Alpha Fund runs about $25 million. Parker doesn't share performance numbers for compliance reasons, but the firm's mutual fund, which runs a similar strategy, has generated 8% annualized since 2000.

Target Investor

Asked to identify his target investor, Parker says it depends on the fund.

The Hedged Value Fund, he says, is essentially “a better mousetrap” for investors in mid- to large-cap stocks.

“We target high net-worth individuals, particularly taxable individuals, because of the tax benefits," Parker says. Currently option profits are taxed 60% long-term, 40% short-term, regardless of holding period. "But we also give you a better rate of return with lower volatility even without those tax benefits. Those three stories play well to high net-worth individuals who, by definition, have equity exposure, typically have it unhedged and should have it hedged.”

The new fund, which is market neutral, also targets high net-worths, but with a difference.

“If you want U.S. equity exposure, go to our old fund, but if you want to have an absolute return—which does not mean  profits every month or every year—that's tax advantaged, you want to go with the new fund. It's really the same people; the difference, I would say, is funds of funds would have no interest in the old fund, because they don't want funds with high beta and high correlation with the stock market. The new fund, they would be interested in because of its alpha generation and its non-correlation with the stock market.”

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