Lee Munson and Lorn Owen Davis provide independent fund research on Natixis Gateway Fund (GATEX).

An investor doesn’t need to look any further than the performance of Dodge & Cox’s stock fund (DODGX) last year to realize that the investment environment has been turned upside down. Even the professionals can make big mistakes that cost money and cash flow for investors. It makes one pause and look for alternatives, such as Natixis’ Gateway Fund (GATEX), which attempts to track the S&P 500 with less volatility and thus less return. With an emphasis on dividend producing stocks, the fund engages in selling index calls to increase cash flow and buying index puts for downside protection. It is a long term investment vehicle similar to DODGX in the sense of large cap domestic companies, but has the added bonus of reducing volatility through its hedging.

Because both DODGX and GATEX have long-term investment horizons it would be beneficial to compare the two with the S&P 500 as a benchmark. Looking at the performance chart for the past 15 years, starting right before the tech bubble, investors would have been wise to just park money in an index fund as the S&P 500 has returned close to 100%. But starting from January, 2000 right before the tech bubble’s peak, GATEX has outperformed both DODGX and the index by at least 20%. In addition to an investment horizon, investors must think about whether they adhere to the idea of a business cycle, for if they do not then they should just index all the way. But if they do and the market is producing little to no growth coupled with high levels of volatility then they should be hedged. Really? You don’t believe in the business cycle? We hope you have 30 to 50 years to ride it out.

From a performance perspective as well as strategically speaking, GATEX is a much more promising and robust package than DODGX or indexing when you are in the middle of a bear market. DODGX is a strategically locked box format fund, a bad place to be in the depths of a bear market. And at the end of the day, the people behind DODGX didn’t realize that AIG or Fannie Mae or any of the other financial companies they invested in last year were fundamentally terrible investments. So, why bother? If an investor is looking for a steady revenue stream, DODGX with their long positions in companies doesn’t cut it. At least you can get some downside protection and higher cash flow while being long stock with GATEX. It’s the sort of fund that one invests in when unsure of where the market is going, like our current situation of a market moving forward in recent months though still in the midst of a bear market. Also, if the market goes sideways after a push up, you can sit back and collect the call premium.

The core portfolio of GATEX is broadly diversified with the intent of loosely mimicking the S&P 500 but selects its holdings based on whether they pay an above average dividend. This gives us the cash flow we’re seeking from equities. The fund supplements its cash flow through its strategy of writing index calls and buying index puts. By writing their own index calls, meaning they have a neutral view on the index for the short term, the managers of GATEX put a limit on the profitability of increases in value of the equity portfolio in return for a steady inflow of cash coming from selling the call options at a premium. Even if the calls are exercised, the fund will only lose the difference between the strike price and the market price while still pocketing the premium. This reduces the volatility of the fund because it provides some downside protection by selling potential gains. This won’t, however, protect investors from serious losses. In the case of an extreme downturn the fund relies on the index puts it has purchased as a safety net. Last year the fund was down about 11% in the fourth quarter – not bad considering they hold large cap stocks and the S+P 500 was down over 21.94%.

But this doesn’t mean that they always have puts to hedge; they allow themselves the discretion to not purchase any puts if they are feeling particularly bullish and wish to try and capture some more gains by not having the extra expense of buying the puts. As of 6/19/2009 their options profile states that they are 100% hedged with written calls and 80-95% with puts, demonstrating that they are a little wary of the market right now. It must be kept in mind that they are writing calls for the cash premium only, and are not buying call options for the potential gains. In fact writing the calls accounts for 15-20% of the annualized cash flow.

GATEX offers an alternative income generator for times when the long funds are unsure of how to correctly evaluate equities and index funds simply don’t produce. It offers investors a way to swap out of long only large cap managers during bearish times without giving up all of your exposure or simply cashing out. For those who are unsure of the market trend, or simply want a more moderate approach to risky assets, this fund can provide a strong base.

Tags: bear market strategy, Calls, DODGX, GATEX, lee munson, Natixis Gateway Fund, options, Puts, S&P 500