Q: What is the history of the fund?

The BPV Wealth Preservation Fund was launched in the mutual fund format in October 2011, however, Quintium Advisors has been managing the strategy in other formats since 2009.

For the mutual fund we currently have $88 million in assets under management, and in the strategy as a whole we manage $165 million.

Q: What core beliefs drive your investment philosophy?

Our philosophy is to provide attractive risk-adjusted returns, either comparable returns for less risk or more return for the same amount of risk. Our goal is to limit drawdown and volatility relative to the S&P 500 Index.

Q: What is your investment strategy?

We are a risk-managed strategy. Everything we do is on a risk-adjusted basis. Since we own a core liquid equity position, we hedge our underlying equity position with a variety of option strategies that are dynamic and flexible.

We have a basket of option strategies, each of which serves its own specific purpose in the portfolio. We combine many of these simultaneously; however, we adjust the weightings based on, and depending upon, our assessment of the current environment. Long puts are the cornerstone of our strategy, but we also have combinations of put spreads. We use short calls to manage volatility. We also use upside call spreads, collars, and risk-reversals, which is simply the inverse of a collar, or essentially the sale of a put and the purchase of a call.

We do not use leverage in the fund, and we don’t have credit or direct interest rate risk in our portfolio.

There are three primary components that go into our analysis in terms of how we position the strategy and the fund; equity markets and valuation, specifically related to the S&P 500 Index, the volatility environment, and the options market.

Regarding the equity market, we use several valuation metrics to understand it: trailing price-to-earnings or forward price-to-earnings ratios, cyclically adjusted price-to-earnings model, and the Fed model in assessing where we are in the U.S. economy’s overall business cycle. 

In terms of the volatility environment, the VIX, or the CBOE Volatility Index, is one measure that we look at but our approach is more involved than that. We look at the volatility of puts vs. that of calls. Owning long puts is core to our strategy. The cost of those puts is key to understanding both the relative and the absolute cost of our hedging activity in a given environment, and so we analyze both put and call volatility.

We also analyze implied vs. realized volatility to determine whether certain option premiums are trading at a premium or discount to the underlying volatility. We monitor different volatility measures for various strikes and expirations that help us to gauge which options are more attractive to buy or sell given the volatility environment.

For the third component, the options market, we analyze a variety of different structures. Again, we have six or seven different strategies, in addition to the long puts that make up our downside protection. Because this fund is focused on drawdown, we attempt to dramatically minimize that, given our exposures.

In scenarios where the market would draw down, say, more than 7%, we expect to realize approximately 25% of that drawdown. Similarly, on the upside, once the market is above a return of high-single digits, we anticipate a capture rate of approximately 25% to 30%. In the bands in between, -7% to +5%, capture rates can vary substantially, depending upon the volatility environments and the strategies we employ.

Even though we have historically owned our equity exposure through a single ETF-based security, we spend a lot of time analyzing the equity markets and what’s occurring in individual sectors and companies. We do that not to make a call on an individual sector or company, but look to identify common threads and themes in the market at any given time. A recent example of this would be the impact of a strong dollar on revenue and earnings.

Q: How do you engineer your research process?

We have a rigorous and repeatable process. Our team meets daily to discuss topical events in three categories: world, market, and company events. Recently, we’ve looked at Greece and China, the quantitative easing in Europe and how that might impact European and domestic markets.

During earnings season we discuss individual companies and potential tactical adjustments. We screen 200–250 earnings calls in any given quarter to understand what’s going on in the market. We believe we add value with our tactical adjustments. We evaluate potential adjustments to our option positions with the goal of improving the risk/reward relationship of the portfolio. One method we employ to accomplish this is to analyze capture rates on upside vs. downside moves, intending to secure capture rates in up markets that are higher than those in down markets, giving us a capture ratio of greater than 1. This may allow the fund to recover from a drawdown at a quicker pace than the broader market.

One benefit of having securities with both long and short directional exposure, and a flexible mandate, is that when the market moves, we have the potential to make adjustments to improve the portfolio’s risk/reward relationship going forward. Most of our exposure derives from the expression of our option positions. We don’t necessarily buy or sell more shares. Instead, we use tactical adjustments to our option positions to get us to our target exposure.

Typically, we use options with 3–6 month expirations, and ladder them, because one of the benefits we offer is our ability to consider the amount of protection that we own and, more importantly, how we are trying to pay for it and when to buy it. That way, depending on the volatility environment, we might sell some short puts underneath the long puts and/or some level of short calls to help manage the cost of those long puts. 

We have a proprietary model that we built that allows us to analyze each individual position. We also stress-test the portfolio, given the upside or downside market moves, in terms of both moves in the equity position itself and volatility environment changes.

Our security selection manifests itself in two ways: the multiple different option strategies I mentioned and, in some environments, overweighting an individual type of option position. We aim to minimize the cost of the hedge and capture as much upside as possible, efficiently managing the cost of that hedge, given different valuation and volatility environments.

Q: Can you illustrate your research process with a couple of examples?

In terms of the tactical shifts we make, based on changes in the market, the October 2014 downturn serves as one example.

Again, our fund is a risk-managed strategy, and our long puts form the cornerstone of our portfolio. When there is a big drawdown, there are four distinct actions that we may take to make tactical adjustments in an attempt to improve the risk/reward relationship of the portfolio. The first is to cover short calls. The second is to sell short puts underneath the long puts we already own in an attempt to lower the cost of the hedge and take advantage of higher volatility. 

The third action is to initiate a risk reversal, which is a synthetic way to use options to effectively increase long exposure by selling short puts and buying calls. Executing a ratio risk reversal simply means that for every put we sell, we look to buy more than one call from the proceeds. That ratio can be as high as 4:1, which allows us to have the downside risk of one share with the upside opportunity of as many as four shares. That provides us an attractive risk/reward relationship. 

The fourth and most powerful action that we can take is to directly sell the long puts we currently own.

In October 2014, we took three of those four actions and covered many of our short calls outright. We sold a large component of short puts underneath our long puts, which allowed us to take advantage of the volatility and also minimized the cost of our hedge. Then we initiated a pretty sizeable ratio risk reversal, the sale of additional short puts and the purchase of long calls, which, if the market stayed where it was, would allow us to avoid being impacted in any way, and if it bounced back, we would have a nice capture rate on the upside.

As a result, from the second half of October all the way through December, our capture rate was much higher than it had been on the downside, during October’s drawdown period. 

Another example, which highlights the benefit of having a flexible mandate, has occurred more recently in how we execute a collar. In the BPV Wealth Preservation Fund we use what’s known as a 5% collar, which on an unadjusted basis simply means that we are looking at buying a long put that is 5% out of the money and selling a short call that is 5% out of the money, and then evaluating the relative relationship between the put and the call.

Back in mid-2013, executing a 5% collar was a very effective hedging tool. The cost of that collar was essentially cash-neutral, meaning that the amount of proceeds that you could get for the short call would be enough to offset the cost of the put, so, on a relative basis, the cost of protection in 2013 was very inexpensive.

If you fast forward to June 2015, that same trade is now a significant debit making it much less attractive. The relationship between puts and calls has recently been at the 99.9 percentile of its range since the inception of the fund, so the relative cost of the put, the 5% out-of-the-money put, relative to the 5% out-of-the-money call, on June 30, 2015, was as high as it had ever been, not because the absolute cost of puts had gone up but because the relative value and volatility of calls had plummeted.  
Said differently, we weren’t getting paid enough for selling the call and it wasn’t worth selling a 5% out-of-the-money call that would cap our upside. So, we adjusted our strategy to sell fewer in the money calls to collect a similar amount of time value. It dampens our volatility on the downside, but also gives us more upside, should the market rise.

Both of these examples highlight the benefit of having a flexible mandate in how we use our option strategies to try to improve the effectiveness of our hedging activities. The tactical adjustments we made in October 2014 demonstrate how we can adjust individual positions when the market moves to try to improve the risk/reward relationship of the portfolio in the short term. This subtle change we made this year in how we execute our collars in July 2015 vs. July 2013 shows how we can modify our hedging strategy to reflect changes in the volatility and valuation environment. 

Q: How do you construct your portfolio?

Our underlying equity position is elegant and simple. As mentioned before, our equity exposure has historically been in only one security, SPY, the SPDR S&P500, exchange traded fund. Generally, our market exposure varies from 15% to 50%, averaging around 25%. 

We do not own individual names—our underlying equity position derives wholly through exchange-traded funds, ETFs, with that single security. We believe the SPY provides industry diversification.

Q: What is the rationale for choosing the S&P 500 Index over other benchmarks?

One reason is that we spend a lot of time understanding the companies in the S&P 500 Index. It is, as an underlying security in ETF form, the largest and most liquid. Since we don’t own individual names, ETF liquidity is important to us. Similarly, the underlying liquidity of the options is important, and the SPY-related options are also the most liquid, so we generally don’t have liquidity concerns.

We typically hold 50% and 75% of the fund’s value in one security and hedge it through various option positions. Our equity valuation target is based on the S&P 500 index.

In terms of the risk/return relationship, we assess whether to have more or less exposure relative to the previous two or three years. To us, risk/return in equity markets, specifically the S&P 500, is less attractive now than in the last 3–4 years. 

Valuation multiples have expanded dramatically and we’ve come from forward P/Es of 12–13 to 17-plus, a near all-time high. There’s room for additional expansion, but not much, making S&P 500 appreciation more dependent on earnings growth, but in 2015, that’s less attractive than historically primarily due to a stronger dollar and the declining price of oil. Earnings growth is estimated at about 1.5%, but ex-energy earnings are still reasonably good. 

At the end of 2014, the S&P 500’s annual overall earnings growth was estimated to grow at 8%, which is respectable, and the estimate for 2015 Q1 was a 4% increase. But at the end of March 2015, the Q1 estimate went from a +4% to -5%, a huge downward swing, bringing the annual earnings growth expectation down from 8% to 1.7%.

As we reached the end of June, Q1 earnings came in better than expected, so we beat the -5% number, but on a year-over-year basis, we were up 0.93% relative to the first quarter of 2014. By then analysts had revised their June quarter estimate to a 4.5% earnings decline, and for the third quarter the earnings estimate was revised from a positive 1.4% at the end of March to a -1.1%, and now the fourth quarter earnings need to be positive for us to achieve a positive year in 2015.

So, we have adjusted our equity exposure down in 2015, relative to 2014, putting us at about 5 to 8 points less, depending on the day.

Q: What is your perception of volatility for 2015?

In December 2014, the volatility environment was high and the VIX, the Volatility Index, was up at that point in time for three reasons. First, the price of oil during the fourth quarter was falling and hadn’t yet found a bottom, so there was a lot of panic concerning how low oil might go. Second, the dollar was appreciating substantially and hadn’t peaked and the third contributor to volatility was the expectation that the Fed would hike rates as early as March, with the general consensus being June. 

We believe all of those factors increased volatility, and any small event moved things around a lot. There were a number of 3%, 4%, and 5% movements in the VIX during December, January, and February. But during the course of the first quarter, something really interesting happened.

By the end of March 2015, volatility had fallen down to low mid-2014 levels, as oil had found a bottom, the dollar stopped appreciating, and Fed Chair Janet Yellen, in her statement after the Fed meeting in March, expressed views that led the market to believe any rate hike would be pushed out. The unknowns, and fear of the unknown, became quantifiable and more certain, remaining that way for much of the second quarter. Volatility subsided.

We’ve remained in that same low volatility environment throughout the second quarter, with the exception of what happened with Greece at the end of June. Once again, we have adjusted our portfolio based on the changing environment. However it appears that the third quarter is on track to look much more like the first quarter, as we are back to the point where the price of oil has fallen, the dollar is appreciating more, and we are, again, roughly 90 days away from an estimated Fed rate hike. If volatility increases, we believe we’ll be poised to take advantage.

Q: How do you manage risk?

We evaluate risk with a proprietary risk management model that we created. Skew and kurtosis are more important to us risk-wise than mean or standard deviation. We try to manage drawdown and avoid catastrophic losses. Our probability model incorporates S&P data between 1928 and 2013 to help us ascertain the expected value of any trades in the portfolio. 

Recognizing that markets don’t have this normal distribution, we essentially fit the data to incorporate extreme value theory, which acknowledges the skew and the possibility that black swan events can and do occur. Then we added the probability of a fatter, negative tail risk event so that, when we do our expected value calculations for the portfolio, it gets us a smaller number, making us more conservative in our decision making. This is very important, with our option expiration strategy of three to six months.

Some of our options extend as far as a year so, given any different expiration date, we anticipate the probability of a market move by any certain percent and we factor that into our scenario analysis. We look at each individual trade, and the expected value of that trade, to determine whether it make sense and serves its purpose. We then layer that into the existing portfolio to see how it impacts the overall portfolio and make sure that the expected overall value of the portfolio is positive. 

It’s also helpful to understand what the drawdown in any given scenario will be. From a stress-test point of view, we scrutinize the portfolio knowing that increases or decreases in volatility will impact both the fund’s exposure and the return. We evaluate this daily and apply it along with our current view of the equity valuations and any other events, and make any necessary tactical adjustments.

There are two important things to note. First, we do not have a black-box computer program telling us what or when to trade. Our tool helps to evaluate circumstances. Second, while we hedge our portfolio, we are not day-trading.

Q: How do you deal with mini black swan events?

You never know when something turbulent will happen. The long puts in our portfolio mean that when something like that happens, instead of panicking, we are positioned to make tactical adjustments that enable us to potentially take advantage of such events.

We can also sell short calls to offset cost. For us, it is more about maintaining protection at a certain level. We have designed the portfolio in a way that is intended to capture as much of the upside in such circumstances as possible. Our strategy may allow our investors to stay invested and avoid selling at the wrong time.