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Submitted by Zega Financial on September 4th, 2014

By Wayne Ferbert

At ZEGA Financial, we have been managing market neutral portfolios for several of our clients for several years now. We believe that this strategy can be very effective as a conservative income producing portion of a risk-averse portfolio. It can be ideal for the client in retirement or near retirement as it can produce consistent returns with very low volatility.

What is a market neutral portfolio? At its core, it means the investor has equally sized bullish and bearish positions in the market. The bullish and bearish positions should have a relatively high level of historic correlation in their performance. So you can imagine: the portfolio tends to move up and down in small increments because the two positions tend to counter-act each other.

So why invest in that strategy? Where are the returns? At ZEGA, we look to produce returns in three formats: (1) dividends; (2) out-performance of the bullish equity portfolio; (3) options premium produced by the bearish market position. In fact, we look to target a consistent 6 to 8% annual return from just components (1) & (3) in the prior sentence. And we look to produce those returns with a portfolio that has very low market volatility.

Notice how I specifically called out that we create bullish and bearish positions not necessarily long and short positions. At ZEGA, 99% of our clients investments are in options and ETFs. We can create bullish positions with long or short options positions or even long or short ETFs depending on whether we want to use one of the more exotic inverse ETFs that exist. It is the creativity offered by the 4 sided nature of options that allows us to produce these kinds of strategies.

So, how do we do it?

All of the market neutral strategies that we run for clients have two components: a bullish US Equity component and a bearish S&P 500 position. We create the bullish US Equity positions with long equity or ETF holdings. To produce a bearish S&P 500 position, we use options. Specifically, selling ITM call spreads about 30-60 days out is our preferred method.

For the clients that we work with on this strategy, the long US equity portfolio is often designed by the client himself — or in close consult with our ZEGA managers. For the client that doesnt have the appetite to pick his own stocks, we recommend a long position in the SDOG exchange traded fund (ETF). It is the dogs of the S&P 500. It holds 50 stocks the 5 highest dividend yielding stocks in each of the 10 S&P500 sectors. It then equal weights the investments at the time of the re-balance which is just once per year.

The SDOG has performed in line with the S&P500 since its inception on July 16, 2012. The following chart is simply the closing price of both SDOG and the S&P500 since the SDOG inception date. These returns are not adjusted for dividends for the 2+ years shown it is simply the price performance alone.

20Sep%203%20GSPC%20SDOG.png /%

The two investments, as you can see, are highly correlated and nearly identical over the entire time period. The return on the price alone over the 2+ years is 48.5% for SDOG and it is 47.8% for the S&P 500 index. But this is the returns on the price and index alone the dividends are not taken in to account. The SDOG purchases the highest yielding companies so it has averaged above 3.5% dividend returns since inception (currently around 3.3% at todays prices on a TTM basis). The S&P 500 has returned around a 2% dividend.

So, with price performance identical, you can capture the dividend spread with this strategy. In fact, by using the SPX (a futures index option) to be bearish the S&P 500, you can increase the dividend spread. The SPX is an index option alone there is no dividend inherent in the index other than the fact that stocks trade ex-dividend and the index is the roll-up of the stocks. But the chart above shows the price returns alone and they are even. So, by being short the SPX call spread, you can effectively capture the entire 3.5% dividend spread as long as the SDOG and SPX perform in line with each other.

As for the call spread in the SPX, with volatility at all time lows, the call spread does not have a lot of time value premium that you can sell but there is some. We think you can comfortably capture around 2 to 4% annually at these low volatility levels by selling between 40-60 days out. We usually look to capture around half of one percent of time value by selling the deep ITM call and purchasing a deep OTM call. How ITM do we sell? Usually at least 5% ITM or as far as we can while still collecting a net time value of no less than 1/3 of 1% for a 60 day call spread.

Make sure to size the SDOG position and the implied value of the SPX bearish position to be the same. For example, if you sell one call spread in SPX, that is roughly $200k in implied S&P 500 control. So be sure to purchase $200k in SDOG to match it up. You may need to look to re-balance the position in SDOG keep both positions properly sized.

Well keep you up to date on the performance of this portfolio approach over time. Remember that market neutral is a version of being hedged you have protected a good portion of your portfolio with the short call position. Good luck!

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