Q: Would you give us an overview of the fund?
Crossmark Global Investments, founded in 1987, is an independent investment advisor headquartered in Houston, Texas. The firm serves retail and institutional investors across the country.
Crossmark Steward Covered Call Income Fund was launched on December 15, 2017. It is part of the Steward family of funds, which includes Steward Large-Cap Enhanced Index Fund, Steward Small and Mid Cap Enhanced Index Fund, Steward International Enhanced Index Fund, Steward Select Bond Fund and Steward Global Equity Income Fund.
A key feature of all Steward Funds is the values-based screening methodology, which allows investors to avoid businesses that contradict their values. The Steward screens exclude companies involved with alcohol, tobacco, gambling and mature content. In that space, we have a lot of traction with the millennials and the rapidly growing number of investors, who seek competitive returns without compromising personal convictions, values or social issue basis.
The fund provides income potential and limited capital appreciation. Although it is only 60 days old, we have already seen different ways in which the fund can perform. It may lag when the markets are going up, but when volatility comes back, the Covered Call fund will outperform.
Q: What is the size of the fund and the company?
Crossmark has about $5 billion in assets under management. That includes the Steward family of funds with about $1.5 billion in assets under management, our institutional index-based business, and the separately managed accounts through several partners. Right now, the Covered Call fund is seeded with $25 million.
Q: What core beliefs guide your investment philosophy?
We believe that there’s a need for a covered call option on the market, especially for the investors who couldn’t meet an SMA type minimum. Our covered call strategy received a lot of traction on the SMA side, so we decided that creating a covered call mutual fund, which applies the values-based screening methodology, would make a lot of sense.
The idea is to allow investors to access the return profile without compromising their personal convictions. The Steward screens, added to the mutual fund, have been a driver and a catalyst. In addition, covered call investors have been looking for yield. There has been the need for a fund that provides not only limited capital appreciation but also enhanced income. That’s the philosophy behind creating a covered call fund within the Steward Funds strategy.
Markets are inherently volatile and fragile, but there are times when we can protect our downside by coverage through options and other instruments. We have to give up some upside to have a covered call and the result is more sustainable returns instead of a volatile return pattern.
The fund is based on an index, so the value comes from the option overlay standpoint, which helps to offset losses over the course of a market cycle. For instance, in 2008 our SMA strategy was down 25%, compared to a decline of 36% in the S&P 500 Index. Last year, when the S&P 500 was up 21%, our SMA strategy was up 16%.
In other words, the strategy represents investing with shock absorbers. If the market goes up, the fund is going to lag because the upside is kept. But when the market goes down, we are going to outperform, because the sale of the covered call will offset some of the market losses. When the market is flat, we will get the income that we generate from the option overlay. That really helps from a performance standpoint.
Since 2008, the market has had an unprecedented nine-year run, so we expect a change from a volatility standpoint. Obviously, the asset allocation is structured to avoid being 100% long in 2008 or 100% in fixed income in 2013 or 2017. The fund is meant to complement a large-cap strategy, a fixed income strategy, or a global one.
Q: How do you incorporate your core beliefs into your investment process?
The fund is based on the S&P 100 Index and the Steward values-based screening methodology is applied on top of it. That structure in itself removes a lot of the risk.
We start with the S&P 100 index names and our screens remove 12 of those names. So we begin with a portfolio of 88 names and then we optimize it for risk control to the S&P 500 Index. The portfolio is inherently close to the S&P 500 in terms of sector diversification but we are buying the S&P 100 and then adding the Steward values-based screens.
The next step is the option overlay. Our holding period of a stock is tied to whatever option we sell. The option overlay involves a lot of technical analysis focused on price momentum, term structure, earnings, dividend date, where we get the most premium in the term structure, and where we want to sell that option.
Since the fund is based on an index, we already know what the 88 names are going to be. The names are the easy part, but the big value-added is trying to be at least 90% covered at all times. We enhance the income by trying to cover up as much of the underlying basket of stocks as we can.
Our extensive experience and history with our SMA strategy has given us a lot of knowledge on the option overlay. The fund is similar to the SMA strategy, because it is market driven from a volatility standpoint, but we don’t write LEAPS, or long-term equity anticipation securities. Instead, the options are staggered by design, based on the sector, the earnings and dividend payment dates.
Overall, the option overlay is the big catalyst behind the performance and the value added at the fund. Otherwise, it is an S&P 100 index fund.
Q: What other factors are involved in your process?
The most important factor is always going to be covered calls. Again, because we already know what our basket of stocks is, the value added is the option overlay. The analytics that go into building the option overlay portfolio are the key element, especially in terms of staggering the options based on sector, earnings announcements and dividend payments dates. Since this is an enhanced income product, we want to capture as many dividends as possible.
It’s a strategy that could be traded every day, if needed, because there’s so much volatility right now on the market. The fund is only 60 days old, so we are still adjusting the option overlay and how it is going to play in the long run, but that’s the concept for setting it up.
Q: Could you illustrate the process with some examples? What do you monitor daily?
We monitor the dividend dates and the earnings release date on a daily basis to know when the next dividend dates are coming up and what options are written on. When holding an index basket of 88 names, there will be market movement on some stocks in any given day, whether it’s positive or negative.
Of course, we wouldn’t chase every event, because that would increase the transaction cost, but there are trading opportunities that add to the performance. We can enhance the income through certain trades and the option overlay is the driver behind the fund.
From a daily trading perspective, it is important to know what’s happening in each sector. For example, Walmart had a recent blow-up because online sales fell. The stock tumbled down by 10 percent. When we are written on a March $105 option and Walmart is at $102, there’s nothing to do with the option. We’ve sold it, collected the premium, and the stock opened up down 10% at $94.
In terms of trading, we could take that March $105 and roll it down to a March $97.50, so we are staying in a front month and collecting another dollar in income. It is all relative. We are only on a front month, which is the front month from February’s expiration. With a short expiration, there isn’t a whole lot of time left, but we were able to pick up a little bit of extra income by rolling it down. Later, when the company released its earnings, we were able to capitalize on this news-based event from a trading standpoint.
We can decide to cover half of the position and leave the other half uncovered. If Walmart has great earnings and the stock goes up, then we would be able to participate in the full upside of the uncovered position.
One of the important nuances of the trading desk is timing the option. It is a true income enhancement strategy and we want to drive the option overlay up to about 90% when possible, because that’s the philosophy and design of the fund.
Q: How do you redeploy capital when stocks get called away?
Because of the option overlay, these scenarios happen every month. For example, in February four names were called away. Because of the nature of an index fund, we’ll buy these names back but we’ll optimize their weight. When a name gets called out, that means that the price has gone up, so we want to move back to the original weight in the S&P 500. We keep as little cash as possible and we are invested fully right after expiration.
So, we’ll buy back the four names that got called away at the pre-determined sector weight of the S&P 500. Based on where the stock is trading, we’ll determine how many shares we are buying back. We don’t just sit on cash after something has gone away - we would immediately put that cash back and we would start the option overlay process again. It’s a revolving cycle, exactly because names get called away and expire. The time between two expirations is our trading opportunity to enhance the income.
When we are buying the names back, we do full optimization across the underlying basket of stocks. We redeploy the cash across the full basket of stocks, but most of the cash will replenish the names that were called away. When a name is called away, it means that the stock price is up, so we have a little extra cash to deploy to other names as well.
Q: What is the rationale behind going back to the same exact 100 stocks?
The rationale is that the fund is based on the S&P 100, with the Steward values added and optimized risk control to the S&P 500. We would lose a name only if it contradicts values-based investing or if it was dropped from the index. Whenever the S&P 100 decides to drop or add a name, we will make a change to the underlying basket.
Q: What is your approach when a stock goes up considerably in a month?
We target our hedge ratio around 35% so, on average, we are writing anywhere from 5% to 8% out of the money on any given option on an underlying name. So, we try to get as much upside as we can without affecting the integrity of the overall philosophy of the fund, which is covered call income enhancement.
In covered calls, when a stock goes up 20%, it is similar to the market going up 20%. In that case, performance will lag behind, but we don’t deviate from our strategy.
Q: Would you describe your portfolio construction process?
The allocation to names in the portfolio represents optimized risk controlled to the S&P 500 Index. The idea is to be fairly sector neutral to the S&P 500 from a risk control standpoint with the 88 underlying names.
We target to be close to 90% written with a delta or hedge ratio around 35% and we are writing 5% to 8% out of the money on average.
The primary benchmark of the fund is the S&P 500 Covered Call Index. We also use the BXM Index as a secondary benchmark. We are in between the S&P Covered Call Index and the BXM, depending on what the market is doing. There isn’t a great benchmark for a covered call strategy out there, so we use two benchmarks to compare to.
The S&P 100 is reference tool from a performance standpoint because that’s our basket of stocks. But because of the true option overlay, we look at the S&P Covered Call Index as the benchmark. From a methodology standpoint, that’s closer to the objectives and the nature of our fund.
Q: How do you define and manage risk?
We try to eliminate as much underlying stock risk as we can, because we are risk controlled with the S&P 500.
In a down market, the option overlay removes a lot of the downside risk by negating some of the losses over time. However, in a bull market, such as the one in the last nine years, covered call strategies lag behind, because we don’t get the full upside capital appreciation.
A covered call mutual fund mitigates the volatility events from a risk standpoint. With this type of strategy, you need a full market cycle to get its inherent benefits.
