Q: What is the history of the company and the fund? A: RiverNorth is a Chicago-based investment management firm founded in 2000. The firm typically favors under-followed, specialty asset classes and markets where the potential to exploit inefficiencies is greatest. As of April 30, 2013, RiverNorth manages approximately $2.4 billion in various mutual funds and limited partnerships. Historically. the firm’s strategies have focused on closed-end fund investing. The Dynamic Buy-Write Fund is the first RiverNorth fund to focus on equity volatility. My background is trading volatility in the proprietary trading and hedge fund worlds. I try to isolate that volatility and then profit from changes in it. It is no different than a stock fund manager buying stocks that he thinks are cheap and selling stocks he thinks are expensive; I do the same thing with volatility. We wanted to deliver a unique strategy in a daily liquid mutual fund structure that was not too complicated — for the advisor, for the pension manager, or any investor. The result is a volatility managed buy-write fund. Q: What is your investment philosophy? A: The majority of buy-write funds invest in securities selected through a bottom-up selection process. They will screen the universe for various fundamental metrics or technical indicators. After purchasing those securities the funds then implement a call writing strategy. Forgotten in this process is that the premise of a buy-write strategy is not stock security selection; the premise of a buy-write should be volatility selection. Generating excess returns through stock picking alone is very difficult over the long run. If you have a well-diversified portfolio of 50 or more securities, in essence you have S&P-like market risk and should therefore generate S&P-like returns over the long term. It is my opinion that if I have the same risk profile as the broad market, but a better short-volatility exposure picture, then I have a better buy-write strategy. You want to choose options that mitigate portfolio volatility and at the same time benefit from stock appreciation. For example, if you are bullish on Microsoft, there is no reason to be selling calls on the stock. You would only enter a covered-call position if you felt the volatility levels were sufficient given the cost of the option. I think that if we can consistently generate alpha by trading volatility, and construct a diversified portfolio so the downside is protected during periods of minimal volatility, then investors are going to realize value. Conversely, when there are no opportunities from trading short volatility, we do not want to incur negative returns, so we either ease our exposure or invest in a broad-based index. Again, it is important to note that we are moving in and out of securities because options volatility changes, not necessarily because we think a security is going to appreciate in the next 60-90 days. Volatility trading is no different than trading any stock. You want to buy low and sell high. Just like a basket of stocks on any given day may exhibit very little change within the basket, some stocks are flat, some stocks are up and some are down. Volatility is the same way, so market volatility could be flat, but Microsoft volatility could be changing relative to IBM, or relative to Intel or Cisco. As all of these individual volatilities move, they create opportunity. As we are predominantly a buy-write fund, we are looking for expensive volatility to articulate our viewpoint that volatility is too high in a security or in a sector, or in the marketplace in general. Volatility is essentially a way to determine the magnitude in which a particular security will move over a certain amount of time. The relative value components used to evaluate whether volatility is cheap or expensive depends on the time horizon. The thesis of investing in volatility really coincides with the clamor for yield today. The covered call or buy-write arena has garnered a lot of attention because investors are looking to own a basket of securities and then augment yield by selling call premiums. In doing so, if the correct call premiums are not sold, or they are too cheap, potential excess return is not optimized within a portfolio. I believe many investors would like a strategy that has lower volatility than broad equity markets but is still correlated to broad equity markets. Volatility management provides a medium. Essentially 80% of the Fund assets are deployed in a buy-write strategy at all times, but we are very cognizant that this may not always be the most effective representation of a volatility picture. Thus, 20% of the Fund we can either use to offset a short volatility picture, or simply be flat, and then when volatility is deemed more attractive, we can take the 80% up to 100% if desired. Ultimately, we want to provide a market-like risk profile, smooth returns and a unique source of portfolio alpha that is absent from the average investor’s portfolio. The strategy is usually found in a hedge fund or closed-end fund, so I think we are very unique in bringing this to an open-ended mutual fund. Q: What is your investment strategy and process? A: Volatilities move every day, just like stock prices, so all of our technology is built to identify these movements and bring them to our attention to assess whether or not they are worthy of investment. If Microsoft volatility is changing in what we deem an abnormal amount, then it will alert me. If we think we have significant risk-adjusted return in a particular volatility trade, then we will start allocating to the trade. As opportunities change, we are re-ranking our ideas. The turnover in that process is probably only about 10% of the names on a bi-weekly basis. If we rearrange our universe every day there are names that come in and out, but unless they are extremely abnormal moves, we let the trades in the portfolio marinate until the return has either come to fruition or until another opportunity is so attractive that we should swap in Security A and remove Security B. The overarching theme is to keep a diversified risk profile and take the best chance to outperform on the short volatility side. Our benchmark is the CBOE Buy-Write Index. We think this is the appropriate benchmark asit is the only index that even resembles what we are doing. In the majority of buy-write funds, if you own a basket of securities, the beta, or market risk, of owning a basket of securities is one and it truncates to about 0.5 as call options are written against the basket of securities. In the next 30 days, however, beta is going to fluctuate as the market rises or falls. If it rises, beta is going to converge to zero and if it sells off, and that sold call option is now worthless, beta is one. That is a big conundrum for someone investing in a buy-write and we attempt to improve this issue through volatility management. We are not market timers and we are not in the business of guessing the direction of the market. What we are going to do is to adhere to a beta target. We target a very conservative beta range of 0.2 to 0.5, hoping to achieve a beta of 0.3 over the long run. That fluctuation between 0.2 and 0.5 is a function of market movement but what we are trying to do is maintain the best volatility picture that we can construct at each point in time and this should allow us to keep that beta very smooth. If that beta is smooth then the fluctuation of returns of our product is smooth. The allure of the covered call and the buy-write strategy today is to augment yield. Say, for example, that a fund owns a stock that earns a 3%to4% dividend yield, and if the fund sells a call option, it might be able to boost the yield on a per annum basis by 1% or 2%. My problem with this line of thinking is that perhaps the 1% or 2% call premium is too cheap by historical standards. Do you really want to sell that call? We assess the yield augmentation, not so much on a buy-and-hold premise, but if yield is, for example, 5% on a per annum basis and it contracts in two weeks to what would be a 3% per annum number, that 2% is alpha to your bottom-line and you might want to reduce exposure to that. Option premiums expand and contract like an accordion and we attempt to capture some of the movement. This is the primary difference in our investment strategy and other funds that use options. While a lot of the managers in our space today are using options for yield augmentation, if that augmentation pans out much faster than the manager realizes, then they should probably harvest those gains and recycle those profits into a potentially better risk/reward investment. As option premiums are expanding our technology is alerting us to whether or not it is a good risk-adjusted investment, then as options premiums are contracting, if they are in our portfolio, we look to marinate and lock in a portion of those gains. We are doing this over and over again across the universe, which is a very prudent way to consistently have what we deem is the best volatility portfolio. The false image of volatility trading, and what a lot of products are doing, is selling the highest volatilities. They do this because of the high appeal of the yield figure. However, true volatility trading is not selling high volatility; it is selling relative high volatility. If I have a 90% degree of certainty that a stock’s volatility will be lower in the next 60 days, that is a much better investment than another security, whose volatility is four times that, but I only have a 50% chance that it is lower in the next 60 days. The probability of being correct is far more important than the amount of option premium that we are selling. It is a very quantitative strategy in which we are recycling through all of the options that are presented to us. Then we look through those on a very quantitative metric to say that an investment is worthy, based upon its volatility versus itself, versus its peers, versus the S&P, and then we weight the investment accordingly. The overarching theme is that we should give ourselves the best chance on a risk-adjusted basis to get an index-like beta to capture the best short volatility picture. Whether that is in low or high volatility stocks, dividend paying, non-dividend paying, value or growth stocks, those mantras and investment styles from a fundamental standpoint are cyclical. Q: What is your research process and how do you look for opportunities? A: In the fourth quarter a few themes evolved. We launched October 12th and there was a very drastic market sell-off out of the gate. The market sold off about 6.8% for the first seven weeks after Fund’s inception. We came out of the gate with our target beta at 0.3 and it was comprised of various securities that were pretty scattered in diversification. We were predominantly invested in large caps and were diversified throughout sectors. We did not have many utilities in the fourth quarter, but almost every sector was relatively in balance with an S&P-like sector weighting. Our volatility management really helped us on the down side. As the market sold off aggressively, we expected volatility to rise. In reality, volatility did not rise very much on the sell-off; we wished it would have so it could have potentially given us some opportunities to generate additional alpha. We were able to demonstrate, however, that we could generate positive excess returns in a sell-off, and that our beta was not increasing too quickly. Q: What is your portfolio construction process? A: Assessing how to construct the portfolio is a very detailed process in assessing whether or not each security’s volatility in the portfolio is expensive, historically speaking, relative to itself and relative to the sector it is in. If I am looking at a large-cap technology company, I want to look at whether or not the company’s volatility is deemed expensive to itself first and then whether or not it is expensive relative to all of its peers and other large-cap technology names. At the very least, we have to make sure the volatility in a particular security is at least as attractive as overall market volatility. So if I am investing with ABC Company, and my benchmark is the BXM, then I need to make sure that the volatility in ABC is not only attractive on a stand-alone basis, but is also attractive versus the index. You do this across the universe and then you select your best candidates. The result is that you get a better volatility-managed product than blindly investing in the index. The disconnect is that there becomes some essential tracking error in a security versus the index, so whether or not the stock outperforms the index on a stock basis, I am not as concerned about that. The reason is that I am scattering my investments across many securities and the beta representation should be diversified enough to behave like the index. But whether or not a company outperforms the index — I clearly wish it would — that is not what we are investing in. We are investing in a collective universe of volatility-based investments and the summation of all of those should give us a better picture than an index-like buy-write. The volatilities of our portfolio in the fourth quarter really did not increase, so even though the market sold off, a lot of the portfolio return was from volatility compression, which did not allow our beta to increase all that much. If volatility had expanded, our beta may have increased more than actual. Given the volatility landscape, I want to give our shareholders the best chance, on a risk-adjusted basis, to outperform the benchmark. So how do we do that? By altering maturities, meaning expirations, and by altering strike prices within the security that has a possible opportunity, and then within the sector, we can hopefully deliver over the long term. Normally, our longest option maturity is 90days, but if opportunities were to present themselves we can go as far out as 12 months— so the mandate is flexible. I try to keep maturities between 60 and 120 days with the majority of the portfolio, but we could go less than 30 days if need be and we can go out to a year. After a year the liquidity becomes more scarce, so I try to evaluate investments based upon the liquidity within the options and I do not want to sacrifice liquidity by going out much further than one year. Our potential investment universe is the S&P 500 Index plus other equity securities where there is sufficient options liquidity. That could include an ADR, which would be predominantly large-cap names. Our sweet spot for portfolio holdings in a steady state environment is probably around 100 to 150 securities. Our process is ongoing — security by security, sector by sector, and then most importantly how they behave together at the portfolio level, to really keep an airtight procedure as to how we evaluate risk both at the security level and the sector level, and then we look at this collectively at the portfolio level and ask the question, “Under adverse conditions, if my whole portfolio behaves in a negative way, what would be the max exposure?” Your max exposure then is essentially beta. The most important aspect of what we do is probably how quickly we think we can generate alpha in a position. If we deem options expensive and we think they can deliver bottom-line alpha within three or six weeks, it will drive our position sizing. The more confident we are in our alpha source, the larger we size it, which would also alter which strike and which maturity we choose to invest. Q: How do you define and manage risk? A: The way the portfolio of options behaves collectively is paramount to our success in every market condition. Also, because you are short volatility, when the down markets occur you have to understand that your risk to the market is increasing and act accordingly. Again, this is where we are different from a lot of the funds out there. Their risk management is not from a volatility perspective, but it is from a stock perspective. We are trying to give the fund the best chance to consistently outperform its benchmark in all environments. That is done with a prudent risk management model. It might be overly conservative at times, but you must be conservative because you are always short volatility and volatility can move much faster than stock prices move. If the S&P 500 Index is down 5% and the VIX, a measure of market volatility, could move from 12 to 20 in at the same time. That is a 66% increase and the market is only down 5%. Insofar as vicious markets, sell-offs tend not to be created equally. The tech bubble burst was predominantly tech-driven, whereas the 2007/2008 downdraft was experienced more by financials. Not everything went with it but that was the catalyst. The key in assessing volatility in both of those environments was to understand that the sector weightings in which you were in were very indicative of your fund’s performance regardless of strategy. When you are investing in volatility it is no different, so if I am short volatility and long beta in financials, I need to make sure that if it is a sector-induced sell-off that my risk management processes are in control in all directions from both aspects. More so than that is how the volatilities will behave collectively. If financials sell off and technologies selloff at a lesser pace, what effect does that have on portfolio volatility at the sector level? That relationship and that movement between sectors, between securities within the sector— there are a lot of things that go into play in assessing that, but the true skill in volatility trading is understanding the way volatilities behave together. If a financial crisis like 2008 were to happen again, the two things we have going for us are our beta management and our flexibility in maturities. Your beta is a function of which maturity you invest in. In really volatile cycles, such as 2008, we want to eliminate the volatility of our beta and we can alter our maturities to really offset that. As option premiums increase, that in essence will buffer the volatility of our beta, which will consequently buffer the volatility of our Fund. Those are two different tactical aspects of our Fund that we think provide a lot of risk management in a 2008-style sell-off. In summary, for anybody looking for an alternative equity product, or anyone trying to move out of fixed income into equities, they really need to be cognizant of portfolio volatility, especially as retirement is nearing, especially as the nest egg is intact. Mine is not a get-rich strategy; it is a wealth preservation strategy with a high correlation to equities. We try to tell our investors and potential clients that if they move into equities because they are being forced out on the risk spectrum, they should be cognizant of their portfolio’s beta. If the strategy offers you diversification of anything, it is going to offer you the diversification from portfolio volatility and beta standpoints. These strategies need to risk-managed in a very prudent nature. Our true objective is to deliver risk-adjusted returns that are superior to BXM, our benchmark index. We can either mute the volatility to give you a similar return, or we can give you the same volatility and try to improve on the index return. Depending upon which route we go, whether we err on the side of volatility mitigation to give you a better Sharpe ratio or whether we go the route of increased returns, that path is a function of market conditions. We will never force the issue; we are just going to take what the market gives us. We are not stock pickers. We are not macro-economists, so we do not really know where the market is going to go. We are just going to give our investors the best chance to participate in a superior risk-adjusted return to its benchmark.