Liquid alt offers robust yield with systematic downside protection

Dynamic Funds believes US-equity focused strategy can provide consistent returns through a full market cycle

Liquid alt offers robust yield with systematic downside protection

Consistent returns through a full market cycle – it’s what investors’ dreams are made of and what Dynamic Funds aims to offer through its US equity focused liquid alternative strategy.

Launched in October last year, Dynamic Premium Yield PLUS Fund is the alternative version of Dynamic Premium Yield Fund, with the two combined having about $1.6 billion in assets under management.

The original has been available for almost six years, delivering approximately 7.5% annual return (series F) on ~35% of market beta. During that time, the S&P 500 has produced around 11.5% a year, meaning the fund has returned almost two-thirds of the upside on 30% of the market beta.

Damian Hoang, vice president, portfolio manager and senior derivatives strategist, told WP these represent good risk-adjusted numbers. In the new Dynamic Premium Yield PLUS Fund, with the addition of leverage and offset by more portfolio insurance, this liquid alternative version has the potential to net a higher income stream with similar downside protection compared to the original fund.

Depending on the series, the yield is between 8.5% and 9.5%, (the yield is fixed and pays monthly), which means that over time the Fund needs to generate mid-to-high single digit annual returns.

Hoang said: “We designed the fund to be able to generate mid-to-high single digit annual returns, on average, a year over the full market cycle. But the key is doing it with a lot lower beta than investing in stocks directly (a third to half of the S&P 500 beta).

“We want to earn that income in a way that is not rate sensitive and therefore will behave differently from the typical bonds and bond proxies out there. So, in short, the value proposition of the fund is that it should be able to earn moderate returns on average over the full market cycle with a very low beta versus owning stocks and with a negative correlation to bonds.”

The fund is not designed to chase the market; instead the focus is on providing a consistent return and yield. In a rip roaring bull market the fund’s relative performance will not be as good, even though the fund will likely earn its yield and maybe a bit extra.

Hoang said, however, that in a range-bound market, equities have little return and a lot of volatility, which is where the fund should excel on a relative basis as  it can collect the monthly income (through premiums) by writing puts on the likes of Microsoft, Costco and Pfizer. He explained: “We couldn't care less if these stocks are having a strong year or not – in a range-bound market, we will have a pretty good shot at earning our yield. As such, both on an absolute and relative basis, the fund’s performance should shine.”

In a down market, the fund features robust, predictable downside protection, while still collecting income by writing puts. If the down market lasts long enough, the income collected may even offset a big chunk of any downside.

Advisors can typically utilize the fund in two ways. For a risk-adverse investor, Hoang believes this is a good defensive equity replacement. On the other hand, for people who need income, the liquid alt is designed to offer a good yield.

Hoang said: “It could be a very good diversifier in the income investment bucket with its competitive yield. When you consider the way both funds have negative correlation to bonds and other typical income investments, it makes an even better case for diversifying your income stream.”

On the question of correlation versus stocks, the portfolio manager is clear that the aim is not to have low correlation all the time.  In an upmarket, of course, you want to participate on the upside with stocks and have the ability to “make hay while the sun shines”.

On the other hand, in a down market, the fund aims to capture less downside than the market by having portfolio insurance via a systematic portfolio protection strategy. For every dollar of income it collects writing puts on Microsoft, Costco and Walmart, it invests a certain amount of that income in buying protective puts on the S&P 500 Index and, specifically, the SPY ETF.

“Because of that,” Hoang said, “we can achieve what we think is a sweet spot. For example, on the upside, we participate; on the downside, we have a lot of systematic, repeatable and predictable downside protection that would kick in to minimize downside versus the market.”

Imitators in the market have struggled to achieve the same level of success as Dynamic.  Hoang attributes this to the difficulty of replicating the strategy.  A key success factor for Dynamic is a team of 5 investment professionals and options experts in addition to a trader that are dedicated to the mandate, with the support from a robust investment infrastructure the team has built up over the past 7 years which is not easy to replicate.

All in this is a strategy that Hoang believes to be valuable when stocks and bonds are far from cheap and diversification is as important as it’s ever been. He explained: “My base case view is that we're probably not going to have an imminent recession on our hands. I don't think we're going to have a 30%-plus sell-off from where we are in the next 12 to 18 months. At the same time, we cannot ignore the fact that on many valuation metrics, stocks are not cheap. When you add in the heightened macro uncertainty this is when you want some downside protection.

“I'm not saying take the money off the table, or go and short the market. But having some sort of systematic downside protection that would kick in to help diversify the downside risk is something worth considering at this point of the market cycle and especially given where valuation is.”

With risk management as its raison d'être, the fund is designed to generate consistent returns and robust yield with low beta compared to investing in stocks and with a negative correlation to bonds. Portfolio diversification, with the end goal of generating attractive risk-adjusted returns, is the promise land for many investors and Dynamic’s road-tested strategy could very well be a vehicle to help get investors there.