Q: Would you tell us about the history of the fund?
The Stadion Alternative Income Fund began as a tactical income fund. Basically, it was a core-plus, fixed-income fund that could tactically shift across the duration and spread spectrums. We saw a need in the marketplace for alternative income that was different from traditional bonds, and repurposed the tactical income strategy into this alternative income strategy in April 2015.
Around that time, there were three things going on in the market landscape. First, because yields were so low, we saw investors in fixed-income strategies stretching for yield via duration and spread. It is dangerous when typical conservative strategies start taking on more risk. Second, equity strategies deriving income from dividends were highly exposed to market risk; and third, most other alternative strategies were correlated to each other.
The Stadion Alternative Income Fund follows a methodical, rules-based, and all-weather process designed to derive different sources of revenue while still managing volatility. Because it is not correlated to most funds within its peer group, the fund also offers diversification benefits.
Although assets under management change daily, currently they are just under $100 million in the fund and the strategy’s separately managed accounts, which is up from $4 million when the strategy changed in 2015.
Q: What is your investment philosophy and process?
Our investment process has three steps. First, we build an equity base by screening for high-quality, dividend-paying companies. Second, we collar the portfolio by selling a call and using the proceeds to buy a protective put, which seeks to protect against corrections in the equity markets and dampen volatility. Third, we methodically sell options on a monthly basis in an effort to diversify income sources using a protected option-writing overlay strategy.
There is no such thing as a perfect investment strategy and every process has periods of strength and weakness. However, as a firm, we have more than 20 years of experience managing defensively, using a process that seeks to remove the emotional biases that lead to poor investment decisions. We can add to investors’ outcomes through this fund, which was built upon the foundation of diversification: diversifying the sources of return, diversifying the sources of income, and diversifying the sources of risk.
From a philosophical standpoint, we do not forecast rates, equity market movements, or key political events because we do not believe anyone can forecast markets with reasonable precision regarding direction or timing.
Q: How does this process inform your research?
During the first step, we screen to find 50 companies to build an equity base. The most important screen looks for a persistent or growing dividend. We want that source of income, and then try to isolate that income with a collar.
In the second step, we actually put the collar on the portfolio, but not on each individual company. In fact, we build our collar around the overall portfolio of 50 stocks using the S&P 500 Index options. Market movement within the portfolio is limited to the range imposed by the collar.
Unique to this process is the asymmetrical behavior between our equity portfolio and that protective collar. This asymmetry comes from the flight-to-quality nature of the names in the dividend portfolio, and potentially adds value when combined with the collar during periods of market stress.
If the market declines, but our equities decline less, the put will increase in value. The asymmetry between the equities and the collar is important because it may add value during those periods of market stress.
Like the second step, the third is also completely process driven. We methodically sell S&P index options to seek to provide additional sources of income and manage the fund’s overall exposure to market risk.
We use volatility levels and the portfolio’s current exposure to determine the amount of the trade we are going to put on and the strike prices that we choose. The exposure level dictates the ratio of calls and put options we will sell, and methodically resets the portfolio every month. We have not seen others managing resets in this manner.
With options, theoretical delta tells us how much the value of an option will change given a move in the underlying securities. For example, with a 0.2 delta on an option, if the market moves 1%, we expect to participate in 20% of that move.
When we put theoretical delta on the portfolio, we expect the same sort of market exposure at the moment a trade is put on. But because delta is dependent upon a number of variables, including time and market movement, it is constantly changing. That is why we reset on a monthly basis and also what helps us manage risk over time.
For instance, if the market has drifted and the portfolio has gotten a bit long, we will typically reset it to what we call a “20 delta,” which is roughly a 0.2 exposure to the market at the point in time the trade is put on. In that situation we would typically sell more calls than we do puts. However, if the portfolio were shorter than we wanted – say it has come down below that exposure level – we will typically sell more puts to reset the portfolio to a 0.2 exposure level.
Q: How do you construct the portfolio?
We build the portfolio with 50 equal-weighted equity securities, then build the collar around it, and finally do our option overlay strategy on a monthly basis.
The construction process begins with the first screen of companies which finds those meeting our criteria for a persistent, growing dividend. This results in what might be called a “greatest hits” dividend-payer portfolio: the biggest blue-chip names in dividends are typically found in the portfolio, with dividends being our first source of return.
Sought-after companies must also have solid balance sheets, lower levels of debt, cash flows to support the dividend, and unique flight-to-quality characteristics during periods of market stress – everything that will help a company maintain that persistent dividend. We also look at these historically to anticipate whether the dividend can continue into the future.
After identifying the universe of companies that meet our criteria, the portfolio management team conducts further research to determine the mix of stocks, taking into account sector weights and additional flight-to-quality attributes. We are not looking to add alpha via the screening process, but simply want to construct the portfolio with what we believe are solid dividend-paying securities.
The other two steps are completely process driven. In the second step, we calculate how much of the notional value of the portfolio we seek to protect which is 100% of the current value of the portfolio, and employ a collar by selling a call with a strike price that is roughly 10% out of the money and buy a put that is roughly 10% out of the money to seek to protect to the downside. This gives us a range of accepted volatility and isolates the dividend within that spectrum of return. We always use S&P 500 Index or exchange traded fund (ETF) options.
During the third and final step, we methodically sell S&P 500 Index options to provide an additional source of potential return and also manage the fund’s overall market risk exposure. Figuring out what the ratio of calls to puts should be is where science comes in to play; it is really a calculation we make given where we stand today, knowing that we are going to put the trade on.
On the equity side, we monitor the portfolio for significant company events. Because these are large blue-chip names, market risk is somewhat mitigated. However, if a company were to cut its dividend, we would remove it from the portfolio.
Though our option overly process is performed methodically and repeated every month, the portfolio does not turn over very much, despite having a strict sell discipline on the equities because buying and selling options is not reflected in portfolio turnover.
Q: What other factors could prompt you to consider selling?
We also look for changes in fundamentals that might indicate a company is under stress, which could prevent it from being a flight-to-quality name. Again, in a situation like this, we would look to replace it.
Selling options gives us unique opportunities. While the opening side of the option trade is completely process-driven, the closing side is monitored daily for risk management as well as for profit opportunity.
For example, say an investor planned to sell a one-month option and collect 2%. In a perfect world, the option expires and he collects 2% – that is the most he can make.
However, there is risk that the option will move in the other direction. Assume in this example that within a few days the market moves a fair amount, resulting in that option being worth just 0.1%.
That option has declined in value. The investor sold it for 2% and now has an opportunity to buy it back, lock in 1.9% profit, and at the same time remove the risk should the market reverse course.
At this point, the option has more potential risk than potential return. We would take advantage of the market movement, capture the profit, and limit risk. This is an important part of what we do, and why such a large part of our process is daily monitoring to capture those opportunities and manage risk along the way.
Q: How do you define and manage risk?
We define risk as loss in account value, and focus on outlier risks and avoiding risks associated with equity market corrections. In this fund particularly, this risk management is done via the collar we put in place. For the option overlay, a portion of the premium collected from selling the options is used to purchase protection against rapid market movements in either direction, so we always know the maximum downside risk.
The fund’s benchmark is the Barclay’s Capital U.S. Aggregate Bond Index. Although this is not a bond fund, it still offers a good comparison. We also use the Chicago Board Options Exchange (CBOE) S&P 500 BuyWrite Index. We look to see how our return is relative to both benchmarks.
