Hedge Your Stock Bets Before Market Drops

Walter Sall, founder of the Gateway Fund, says investors should hedge their bets as the market rallies, even if that means missing out on some of the returns.
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BOSTON (TheStreet) -- Walter Sall, founder of the Gateway Fund (GATEX) - Get Report, says investors should hedge their bets as the market rallies, even if that means missing out on some of the returns.

The $4.7 billion fund, which garners three stars from

Morningstar

(MORN) - Get Report

has returned 14% during the past year, outperforming 60% of its peers. The fund has lost 0.8% annually during the past three years, beating more than half of competing funds.

Welcome to

TheStreet's

Fund Manager Five Spot, where America's top mutual fund managers give their investment views in a five-question format.

There's a lot of skepticism about the recent rally in stocks. Are you skeptical as well?

Sall:

We have some degree of skepticism because the market has run so fast. Obviously, the expectations for corporate earnings are running high so if there are disappointments, that could curtail the rally. We don't know, of course, whether that will occur or not, but it is those uncertainties that cause option premiums to be as high as they are. So as long as we are being so generously compensated, we feel that it's appropriate to take those kind of risks and be in a hedged portfolio.

How do you manage risk in the Gateway fund?

Sall:

We manage risk two different ways, typically by selling index options on our diversified portfolio. We are selling index call options which are listed on exchanges and when we sell those call options, typically at the money, we receive cash for them. We use some of the cash we receive to buy index put options. We generally buy those out of the money to protect the portfolio from large declines in the market. Fortunately those don't happen too often but when they do happen, we are glad to have the puts in there. The combination of the short position that we have in the index call options and the long position in the put options gives us a very low risk profile in the overall portfolio.

If we enter another stage of a bull market, aren't you giving up a lot of upside though?

Sall:

We are definitely giving up some upside since we are writing index call options on that portfolio. But we are being compensated very generously by the generous premium income we get when we sell those options. Historically that's averaged around 20% per year. And that goes back over 20 years so there is a lot of history there. And right now we are seeing index call options priced between 18% and 20% per year, so we are seeing very generous cash flows from the sale of these index options compensating us for the upside we give up on the portfolio.

We don't think the market will go up another 63% in the next nine months as it did in the last nine months of last year. But even if it does, it does not mean we won't participate at all, it just means we won't go up as much as the market. But if you are out of the market because you are worried about the risk, you won't participate at all.

Which stocks are best for this type of strategy?

Sall:

We are not picking stocks in a conventional sense. We want to have a broadly diversified portfolio that will reflect what's going on in the marketplace. We also want to make sure that portfolio will have similar performance characteristics to reflect the options that we have sold and bought to protect the value of those assets. In other words, we don't want a mismatch between the portfolio of stocks that we own and the options we use to hedge them. That diversified portfolio does include a lot of large capitalization, multi-national companies that are very well known. Most of our portfolio would be very familiar to domestic U.S. investors.

What's your view of the VIX, or fear index, right now? Is it going to spike up?

Sall:

I would not read that into it right now because looking at it historically its right in the middle of its range. It is typically on average been around 20 historically. Right now it's a little bit below that, but in that middling part of the range. So the VIX is not really telling us if there is a high level of fear in the marketplace, or if there is a low level of fear in the marketplace.

When the market seems to be topping out, then the VIX gets down to around 8 or 10. And when you have very high levels of risk perceived in the market like we did in the fourth quarter of 2008, then the VIX can get up to 70 or 80, so it can fluctuate wildly. So I would have to say it's not really predicting in any way that the market is going to go off to the upside or collapse to the downside.

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Reported by Gregg Greenberg in New York

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Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.