Q: Would you provide an overview of the fund?

The AllianzGI Structured Return Fund was launched in December 2012 as a streamlined version of our institutional products. We wanted to bring our expertise in the index option space – where our team has worked together since 2005 – to the retail marketplace, but package it in a way that would be explainable and understandable, and still deliver a compelling risk/return profile.

Because the index option platform for institutional investors is quite complicated, with complex strategies, hundreds of positions, and typically long sales cycles, we recognized that it would have gating issues in the retail world.

Our team’s institutional product line-up began in September of 2005, with the launch of an absolute return strategy and an enhanced index strategy. Both targeted specific return levels, were consistent with low volatility, and were designed to deliver in nearly any market environment. We saw a need for a streamlined version of our products for the retail space, and in April of 2008 launched a version of our flagship absolute return strategy that ran in seed account until the inception of the mutual fund.

Fast forward to today, we have an entire suite of both absolute return and enhanced index products using index options as excess return generators using basically the same (but refined) strategy that was implemented in 2005. 

Our platform has approximately $5 billion under management with a dozen different applications, including a retail offering in Europe that will be launched in UCITS form at the end of this month. Assets in the Structured Return Fund are just above $200 million. Because it has a retail focus, we do not have separate accounts or other assets managed in the strategy. 

The fund’s name can lead to misconception about what we actually do. This strategy is not a conventional structured product that issues debt, puts out a note, or follows systematic rules explicitly. Unlike others in the liquid alternative space, our belief is that no one is particularly good at calling the direction of volatility over time, so we remain agnostic to both the direction of the market and to volatility levels.

Our interest is less on specific security selection and more on the movement of the underlying index and capturing return across a broad range of market outcomes over time. Though many mutual funds use options, typically those are covered call funds or ones that use put options as protection. Few products, including both retail and institutional, use index options as their primary source of returns. 

At its core, the fund is an absolute return fund designed to generate consistent positive single-digit returns that meet our target objectives in all market environments. Over time, its risk/return profile ends up looking a lot like a fixed-income portfolio – but it does not have credit risk, duration risk, or interest rate risk. Using the index options market in a unique way allows us to generate consistent, low-volatility returns. 

Q: What drives your investment philosophy?

We have done a 90-year statistical lookback on all the indices we trade and developed a proprietary tool to analyze the distribution of expected returns. For the Structured Return fund we focus exclusively on the S&P 500 Index. 

This historical analysis allows us to take an unemotional view of what will likely happen in the market over a short time period. It also helps us avoid taking positions or having expectations of market returns that are unrealistic relative to history. We use this intellectual capital to develop our high probability “forecast” for subsequent market moves; about 90% of the time our distribution and expectations of the future are right.

The sweet spot of our statistical analysis falls within a four-week to 12-week time period where we can identify repeatable patterns, consistent inflection points, and consistent distributions of returns. This mathematical tool helps narrow down our opportunity set within which we make discretionary decisions. We then take positions with a high confidence of successful outcomes based on expected distribution when probability is 85% or higher that the market will behave within a certain range. 

Q: What is your investment strategy and process?

This distribution is the starting point which frames how we design products. It does not necessarily impact day-to-day decisions, because with 90 years of history we do not usually see big changes in expectations over one- to five-day periods. 

In portfolio management, we use our institutional knowledge to take positions going forward which we refer to as profit zones. If a forecast is correct, it allows us to generate expected returns by taking granular positions a couple of times per week, so the most important thing for us is ensure that the strike levels of the index options we choose are correct.

For example, if we think there is a 90% probability the S&P 500 Index will be between 1,975 and 2,225 between now and the end of August, we will take positions for a six-week duration at the outer bands of that range, as well as within the range, in a way that will build up to our annual return targets. 

Two legs make up the fund’s core position. We are long equities through exposure to the S&P 500 via the SPDR S&P 500 ETF, known by its ticker SPY. Then we are selling (or short) against that SPY position an in the money (ITM) S&P 500 Index call option. Because they are paired off dollar for dollar, the marriage of the two delivers a market neutral position down to the strike of the ITM call option. 

As long as the market stays within our forecasted range, consistent returns can be generated. We aim to take positions in the fund and leave them untouched until they expire.

With the exception of the position in the SPY, all the positions in the fund are index options. We are not picking stocks or individual bonds, nor are we making duration or interest rate forecasts. The Structured Return Fund only trades options on the S&P 500, and we focus on selecting strikes there where modest returns can be generated every month. 

The fund has three sources of return: in the money call option premiums, dividend yield from our long passive position in the S&P 500 via the SPY, and returns from a catch-all bucket we refer to as put and call directional spreads. 

In times of high volatility when the market is experiencing sharp movements in both directions, our returns can be modestly smoother than normal. The wide zones that can be taken in a higher volatility environment due to higher option prices allow us to absorb more market movement. This also holds true when there has been a market rally after a big decline. 

The environment where we see modest bumps in performance is when the market moves from low to high volatility – typically, when the equity market is declining.

As the market goes down, our risk management process is to close existing positions and re-layer them to lower strikes if needed. Though some stop losses would be incurred, after taking the positions in a higher-volatility environment, we have the ability to capitalize on that and recoup a portion of our re-layering costs. Ultimately, our returns can be somewhat higher and potentially smoother in a high volatility regime. 

Since we have positions expiring every week, a portion of the portfolio is rolling off and a new position is taken every week, allowing for diversification in our strikes and in our entry and exit points. As long as the market behaves as expected, a position will expire with its option premium having gone to zero, and we will take a new position four to eight weeks from that point forward.

Q: What is your research process and how do you look for opportunities?

Our research process is ongoing and dynamic, but our portfolio is not managed with a rules-based strategy. As I mentioned, we use our historical statistical lookback to help us make discretionary decisions. We are always looking for ways to generate returns more consistently and optimize the risk/return tradeoff, whether through streamlining positions, making modest tweaks to position sizes or to our restructuring process, and reviewing when and how may we intervene in a process. 

These things evolve and are dependent on what is happening in the market, how the volatility surface looks, how steep the skew is, and what the term structure looks like. 

Thinking back to the market dislocation of August 2015 can illustrate our research process. We looked at many market dynamics after that event, for example: what happened to the VIX terms structure; how quickly the market declined and rebounded; the differences between the underlying market mechanics and behavior of August 2015 versus the severe moves in the S&P 500 due the European sovereign debt crisis in August 2011; and different configurations and ratios of positions that could potentially capitalize on certain market movements. We then made modest refinements to our process as part of our ongoing research efforts. These efforts were partially responsible to the smooth portfolio returns in January 2016, when we had another pronounced market decline.

Returns from the “catch-all” bucket – our put and call directional spreads – is another place our research process is used to capitalize on market movements.

In this category are things like premium collection trades, selling calls, hedged put selling positions, directional call spreads, and directional put spreads. These are all small positions that can add mildly to the return stream when we analyze elements of market behavior and optimize the balance between position types. 

Q: How does your portfolio construction process work?

We manage the strategy one trade at a time to get to our annual return targets. Although the index option market is enormous, this fund has simplicity – it is easy to value and follow because we only trade S&P 500 options. By comparison, our institutional product trades five or six different indices. 

The fund has anywhere from 50 to 200 individual option legs. Every position has expiration dates out for four to eight weeks. At least once a week, there are listed expirations, as well as some monthly and quarterly end options. Ideally we hold all of our options until expiration.

We trade the portfolio and put on new positions nearly every day. Though there may be common expirations, different strikes could result – we want the greatest possible diversification of strikes and expiration dates, and do not take large positions in high-conviction names like equity managers would. Diversification grants us flexibility should we need to restructure when the market moves downward.

Q: How do you define and manage risk?

We look at risk in three ways: position size, preparing for the unexpected, and having pre-defined processes that capitalize on an orderly and functioning market environment.

In the index option world, a big determinant of success is sizing a position properly. Options are non-linear, so being incorrectly sized in an adverse market event can result in outsized losses and unacceptable drawdowns. 

We try to ensure appropriate position size by not reacting emotionally to potentially attractive positions the options market might present or by reaching unnecessarily for returns. 

Second, it is necessary to be able to manage risk in a non-functioning market environment. This means not only being prepared for the expected, but also for whatever is most definitely NOT expected. New history is continuously being made, so we have to be prepared for it.

To do this, we have a layer of systematic tail risk hedging positions in the portfolio at all times. This does not necessarily mean the fund will be profitable after an event like the October 1987 crash, but having this tail risk in place will materially mitigate and reduce the drawdown profile of the fund. 

The third layer to risk management is a process that is gone through regularly when the market is orderly and functioning. Even though the market behaves like we expect it to 90% of the time, we must assume at all times that our expectations are going to be wrong.

Having a rigorous process and rules in place helps us limit losses and capitalize on the present market environment. How and when we intervene in this process is well researched. We have a specific set of predefined variables and choices, and how the market is behaving helps narrow this down. 

When a position is taken in the portfolio, we know precisely how we are going to react if the position looks like it will be unsuccessful. We rigorously adhere to guidelines about closing a position, and re-layer it if it looks as though the strike of our short call is going to be pierced. 

From a philosophical standpoint, risk management is preserving the capital of our long SPY exposure, and to that end, our in-the-money calls act as a buffer against a decline in the SPY. If the buffer is violated, it forces us to make sure we have a new, lower-level strike. 

Implied volatility – the VIX, or any other standard measure of volatility – does impact option prices fairly significantly. 

In terms of the option premium we collect, the higher the levels of implied volatility, the bigger the gap between the current level of the market and the strike of our short call options. Volatility becomes a tailwind to our strategy, allowing us to take safer positions from a statistical, forward-looking perspective. 

A volatile market allows us to take wider profit zones and bigger buffers between the level of the market and the strike. We can also potentially generate higher returns because high levels of volatility drive up option prices; for a commensurate amount of risk, we can take modestly more profitable positions.