Tuesday, 9 February 2016
Last updated 17 hours ago
Sep 12 2013 | 2:38pm ET
When MD Sass took a strategy previously restricted to managed accounts and turned it into a mutual fund, it expected retail interest. It did not anticipate how much the MD Sass Equity Income Plus Fund would also appeal to investors.
“We've recently had two large institutions move into the mutual fund,” MD Sass CEO and founder Martin Sass told FINalternatives, “because it's the same people, same strategy, except it's in a very neat format—they have one line on their portfolio.”
The strategy debuted as an open-end mutual fund with a $2,500 minimum investment on June 28. It involves selling out-of-the-money covered call options against stocks with high-and-growing dividend payments, protecting the overall fund’s downside risk with the purchase of out-of-the-money index puts.
“It's currently generating income of about 11.3% annually,” said Sass. “That's comprised of 2.5% dividend income from the stocks and another 8.8% annually from option premium income that we collect from the sale of covered calls. So, even in a standstill equity market, it would generate a gross cash flow of 11.3%. In addition to that, we're hedging this portfolio with index puts, and these are currently about 9% out of the money. At their strike price they will hedge 70% of the downside risk of the portfolio.”
MD Sass manages about $8.5 billion, and roughly half of that is in alternatives, said Sass, primarily hedge and private equity funds. The decision to launch a mutual fund comes at a “watershed” moment for the regulated vehicles.
“There's a movement into alternatives via mutual funds,” he said. “Traditionally, mutual funds were long/only equities, bonds and money-market instruments, but didn't utilize hedging strategies such as we're talking about here, and particularly didn't utilize options or other derivative strategies.”
“We charge a 75-basis-point management fee in these funds with no carry, no percentage of profits. It offers daily liquidity, it offers much better transparency than most hedge funds, and it provides daily net asset value and performance value. It's mark-to-market, so it has a lot of advantages that the mutual fund format can offer both to institutions and retail, which is why you see us offering a mutual fund at this stage of the game.”
Puts & Calls
Sass said purchasing index puts protects against any sharp sell-off in the market, while the cash flow from dividends and option premiums cushions against more modest declines.
“Because there's no free lunch out there, what we're sacrificing is upside. In sharply rising markets, it will tend to underperform,” said Sass. “We're not seeking to beat the market in sharply rising markets; what we're seeking to do is capture a good portion of that upside but all of it, because these out-of-the-money call options put a cap on how high our appreciation can be.”
Since launching the strategy in 2009, it has captured 48% of the downside in the equity market (compared to 64% for the benchmark HFRI index) and 56% of the upside (48% for the HFRI index), while outperforming the average long/short equity hedge fund in the HFRI index by 4.5% annually.
“So, you can see, on the upside we captured more, on the downside we protected better,” said Sass.
At the heart of the Equity Income Plus strategy is the stock portfolio, which Sass said is the result of “real forensic research, fundamental research, which has really been my forte and the only thing that I really know much about since I started in this business 100 years ago.” (For the record, MD Sass was founded in 1972.)
“There's five of us on the equity team. We have a proprietary equity valuation model where we input our own earnings estimates, dividend estimates, cash-flow estimates and other fundamental factors to screen over 1,000 stocks and come out with 30 to 40 that have the best risk/reward profiles. That's how we put together our long-only portfolio, which we call relative-value equities."
“Then, in Equity Income Plus, we put a little twist on that and we demand that the portfolio only be comprised of companies that are paying dividends.”
In fact, the portfolio consists of companies that are growing their dividends “at double-digit rates,” said Sass. "We're not just buying high-yield stocks.”
An example is the only utility they own, an interstate gas pipeline specialist called Williams Co. It pays a 4.1% dividend Sass that expects will grow 20% per year, compounded annually. Another example is Teva Pharmaceutical, primarily a generic drug manufacturer, which “has a 3.3% yield from its dividend, has modest appreciation potential—we think it's got 13% upside over the next year or so—has low downside risk and provides a double-digit return when combined with writing options against it. So Teva actually is generating about 11.5% return for us from cash flow, both from dividends plus the annualized options premium.”
Other stocks, said Sass, fit both the long-only and the EIP portfolios. “They have the stability and the dividend income and the option premium income, and the upside potential in the stock and that's lovely.”
Sass said that while his firm tends to be a long-term investor, it sets price targets on all the stocks in the EIP portfolio and sells any stock that reaches approximate fair value.
“We set those value parameters and we'll set option strategies such that we will intentionally get called away on stocks in our portfolio as they appreciate and reach fair value. We don't have a set timeframe for that, it's just when the stocks appreciate toward fair value we'll sell them or if there's a deterioration in the fundamentals which caused us to buy them in the first place, we'll sell them.”
Equity Income Plus is still “brand new,” said Sass. “We haven't even gone out marketing yet,” but as the average market cap of their companies is about $48 billion, he believes they have a “multi-billion dollar runway” in terms of capacity.
“We're going to pause at $1 billion in this strategy, to see that what I'm saying holds true and there's no diminution in performance with size, but I don't think there should be because we're trading stocks that have size and options that have a lot of liquidity, so we think there's a lot of room to grow this.”
Sass, whose own portfolio is 35% alternatives and who has a “significant personal investment” in EIP, thinks virtually all retail and institutional investors should be looking at alternatives.
“I'm biased, of course, but unless they are totally risk-averse and want to just bury everything in the mattress, I think they should have a portion of their assets in a fund like this as well as other alternatives. I think it's got a place because it adds stability, it reduces volatility, it adds diversification, it enhances income: all good things for a portfolio.”