Q:  How has the Schooner Fund evolved? A : Through the 1990s and the early 2000s convertible arbitrage, merger arbitrage, volatility arbitrage and other arbitrage strategies were the backbone of multi-strategy hedge funds and the entire hedged community. By 2004, we had witnessed how the skill set had become abundant with the availability of both computing power, high end intellect, and a lot of new entrants in the market. One of the challenges we were facing was to think of new ways of employing our skill set in compelling and interesting products that made sense for investors, which led us to the mutual fund world. In 2008, I was one of the founders at Schooner Investment Group, the advisor of our flagship product, the Schooner Fund. At that point, investors were pushing away from the hedge fund structure a little bit. They liked the product and strategies, and the risk reducing elements of low-correlation to traditional assets, but they were concerned with liquidity, operational, structural and regulatory issues. At the same time, we were looking at the traditional long only mutual funds. Investors in those instruments were beginning to get frustrated with the very pedestrian nature of what those products did, leading to an increasing push towards ETFs and index funds. As a whole, the investor community started to question the value and merit of long only active investment vehicles. What we saw as an opportunity was the convergence of the strategies and techniques typically found in hedge funds, aiming at risk reduction, downside loss mitigation and volatility management, with the liquidity, transparency and regulatory framework of mutual funds on the other hand. Our core expertise was built around the equity volatility type trades such as options, convertibles and warrants, and we thought that exposure to them would translate nicely into a product to the general investor public that wanted to change the risk/return profile of long only equity portfolios. Q:  What are the inherent principles of your investment philosophy? A : The mandate of the Schooner Fund is to deliver risk-managed equity exposure by mitigating volatility risk, and declines in the fund, in a risk-controlled manner. Our objective is to outperform the S&P 500 Index as well as other funds in our peer group over a full market cycle, and through meaningfully less volatility, along with dramatically lower drawdown risk. Q:  What is your investment strategy? A : Since our core expertise is built around equity volatility, we look at the equity volatility environment at any given time, aiming to assess what types of trades we can execute around a core basket of large cap domestic equities to achieve our objective. Our strategies encompass covered calls in expensive rich implied volatility environments, and long only convertibles in lower or cheap volatility environments. Generally, we like unpredictable, wild, sporadic markets with their associated high volatility. Those are very opportunistic situations for our type of strategy because they create more mispricing in the volatility spectrum. Q:  How do you actually benefit from “volatility” in your strategy? A : We primarily pay attention to the implied volatility, so VIX is a common measure that we use. Overall, we try to identify environments where implied volatility appears to be expensive to our forecast. We want to be net sellers of premium or net sellers of volatility, which is a great environment for a covered call strategy. The flip side is that when implied volatility is in specific names or aggregates, it is cheaper relative to realized volatility. Convertibles are a super asset class to get long-dated exposure, and that is why we keep volatility embedded within the convertible. As we seek to take advantage of different cycles of volatility, we will construct different types of portfolios with that objective in mind. Q:  How do you execute your covered call strategy? A : Our fund is unique in the way we execute our covered call strategy. Rather than using index options, we use the individual underlying securities and equity volatility-based strategies that make sense in a particular environment. Buy-rights from a risk-adjusted standpoint are a great trade. However, we run the strategy a little bit differently. Instead of waiting till expiration to make our adjustments for strikes, we roll our strikes actively. We feel it is important to have not only the mandate but the skill set to be able to identify those market environments and move to a more appropriate volatility-based trading strategy. Q:  What is your research process for stock selection? A : We start out by running our portfolio through several proprietary screens to arrive at a workable universe of large-cap domestic names that we are interested in. Some of these generic type screens focus on liquidity, sizing and other technical parameters, but we also make some volatility-based assessments. We are not explicitly trying to pick or identify stocks that are going to outperform their sector or the S&P 500 Index. In effect, we look for stocks that are not likely to underperform. To the extent that it is an in-line performer, that is more than good enough for the nature of what we are trying to do with those securities. In terms of how we position a stock, our approach is a function of the volatility pricing environment and how we can hedge most appropriately. We are constantly evaluating the spectrum of underlying securities in depth, and after the quantitative steps we weigh up the volatility term structure. Additional factors of evaluation have to do with how a convertible fits an individual name in terms of pricing and the whole sector we have in the portfolio. After all, the ultimate goal is to determine what a portfolio candidate can do in terms of adding value to the aggregate portfolio. Q:  How do you construct the portfolio? A : We construct a portfolio with the core position in US large Caps. We use additional tools such as selling single name call covered call options, buying convertible securities, put spreads, and other instruments consistent with our mandate. At no time do we allow any leverage into the portfolio. Currently, we have invested about 70% in buy-writes, about 20% outright in high dividend payer sectors like utilities and telecoms, and around 10% is invested in convertibles. The current number of portfolio holdings amounts to 100 securities. We construct the portfolio with the objective to avoid any material sector bias. To that end, we break down that universe into our sector components. The securities that made it through the filter are going to be the candidates for that sector, and as we go through every single name, we assess the availability of options or convertibles on a product if we decide to go the buy-write route on it. Up to 100% of the portfolio might be in a covered call strategy based on pricing of call options. If we feel the implied volatility is expensive, we may want to take advantage of that by selling upside and collecting premium. Our stated turnover in the fund in terms of underlying securities is about 180%. We turn over fairly actively for a traditional mutual fund. Q:  Could you provide an example to highlight your investment strategy? A : For example, if the stock of Caterpillar Inc. was at $95 or so, we could sell the front month $105 strike call for a little over $2. The thesis behind this is that if we are going to buy the stock at $95 and sell somebody else the $105 call, at any time from now up until the third Friday of the month, they are going to pay us $2 for that right. Let us look at where we would be at expiration the last day that the option is live. If the stock has not moved, then the person who bought the stock will have made no money. Because they bought it at $95 and it is still $95, they may have had a little bit of ride in between but the profit remains zero. Whereas, in contrast, if we sell the call, our profit on the stock is zero but we made $2 from selling the call. In a different scenario, let us say the stock goes to the strike, to $104.99. The person who bought the stock would make a profit from $95 to $105. They would make $10, whereas we would make the same move in the stock plus the premium, which would result in $12 for us. In other words, we would perform better than the person who bought the stock up until the strike. If the stock went to $110 by expiration, the person who purchased only the stock would make $15, that is $110 minus $95. For us that would mean $10 plus $2 from the premium we sold, or a total of $12 as opposed to $15. We would participate in 80% of the upside. The nice thing about a covered call is that it also adds protection from the downside because it creates a bit of a buffer. For instance, if the stock went back to $94, the person who bought the stock would effectively lose a dollar because they bought at $95, whereas we would lose a dollar on the stock but collect $2 in premium. That would still leave us with a dollar net. We will always do better on the downside than someone who just bought the stock because we collect some premium. The amount of premium that we collect is a function of implied volatility. Internally, we would like to create portfolios that have 80% upside capture and less than 50% downside capture. Q:  Would you illustrate another situation with an example? A : The core of what we do on the equity side is long only. All the securities we purchase are long and we try not to make sector bets. Even if we do not like financials or we think they are going to underperform, we still want to maintain a sector weighting within financials. But we can structure trades to lean a little bit, if we think there is some directional bias. Again, a lot of testing is reflected in the volatility pricing. If volatility is extremely high and expensive, or implied volatility relative to realized volatility is expensive, we can use covered calls. Let us use an extreme case. If we had Morgan Stanley at $30 and we could sell the one-month calls in an extreme environment, maybe we could sell it for $5. We are basically protected for the first $5 down in the stock, down to $25, and we would not lose any money. From $30 to $20, if the stock went down by 33% or a third, we would lose $10, but still make $5 on the premium. That is just in a static framework. Another important thing we may do is we roll down the strikes. If the stock was $30, we would sell that $35 call for $5. Let us imagine, however, that the stock moved down to $25. At that point, the market price of the $35 call would go down materially because we moved so far away from the strike. If the call somehow went down to $1.50, we might buy back that $35 call and now sell the $30 call because the stock would now be at $25. Thus we would book our profits and provide ourselves some more downside by rolling down the strikes. Q:  How do you determine your equity asset allocation? A : We will do some of that simply by exclusion. We see how some sectors do not lend themselves well to covered call writing, or some names do not lend themselves well to covered call writing, but we still want to get some kind of exposure to those sectors. For instance, to get exposure to telecoms we need to be basically long. Because there are only five names in the entire S&P 500 Index in the telecom sector, we need exposure to those sectors and names. Looking at implied over realized volatility, we may detect that the spread is not meaningful enough to where we want to do covered call strategies, so we would eventually leave them long only. One of the attractive aspects of these names and sectors is that they tend to have lower beta to begin with and are higher dividend payers. The sector weightings in the fund are effectively S&P 500 Index sector weights. Q:  What kinds of risk are you willing to take and what do you generally do to control risk in the portfolio? A : Our belief is that to take advantage of the equity market exposure we need to take some market risks, beta risk. Still, to the extent possible we want to identify ways to mitigate that without taking on other types of risks. We certainly do not want to take any sector allocation risk. At the same time, we want securities to perform in line while having other volatility characteristics that we like. What we seek to achieve is replace them for risk that we feel we are good at managing in order to find alpha and mispriced opportunities materializing through volatility. In terms of explicit portfolio volatility, we want to try to keep the standard deviation of volatility at half of the level in the S&P 500 Index while keeping drawdown at around half the S&P index as well. We are aware that some investors and advisors are looking for risk-mitigated equity capture rather than a high beta, momentum style of investing. Their primary needs are risk management and capital preservation protection that are significantly better than what they would find in an indexed product or another sort of passive long only equity investment.