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Here's a Balanced Fund That Explores the Options

The Bridgeway Balanced fund, run by Dick Cancelmo, hedges its bets to steer clear of heavy losses.

Editor's note: This column first appeared in The Save Safe Plan on Friday, April 11. For more information on The Save Safe Plan, click here.

The options market is a dangerous place to play if you don't know what you're doing. In options, you're betting against another person. One of you will make money. And the other will lose. It's a zero-sum game.

But that doesn't mean these financial instruments are purely speculative. An option can act as insurance policy in case the price of the underlying stock falls. You can use options to increase your risk or lower it.

Dick Cancelmo, manager of the

(BRBPX) - Get Report

Bridgeway Balanced fund, is not one of the speculators. Cancelmo sells options in this stock and bond fund to build a portfolio that has some of the upside of an up market and less of the downside in a down market.

In general, an option gives an investor the right to buy (a call option) or sell (a put) a specific amount of a particular stock at a specified price during a specified time period. If you buy a call, you have the option to buy a stock at a set price at a later date. You're betting the stock will go up. If you buy a put option, you can sell the stock at a set price in the future, and you're wagering that the stock will fall.

But again, there's always another person on the other side of that transaction. Bridgeway's Cancelmo sells puts and calls in this fund to generate an income stream that's lower risk than actually buying stocks.

Broadly speaking, Cancelmo is placing bets with investors who think stocks will go up and those who think stocks will go down. By selling -- or writing -- these options the fund collects income. The buyer of an option has to pay something for each contract -- called a premium -- and the Bridgeway fund gets to keep that money.

When you sell or "write" a put option, you're selling someone the option to sell you a stock at a lower price. This is an insurance policy for the buyer of that option: If the stock collapses the seller -- or the person who wrote that option -- takes on the loss. But if the stock doesn't plummet, the seller keeps the premium collected for selling it in the first place and nothing else.

By writing or selling a covered call, you're selling someone the option to buy a stock you already own from you at a higher price. It's a bet that you don't think the stock goes up much, but you have some cushion in the form of the premium if the stock falls.

Cancelmo uses options along with regular-old stocks and bonds to build a portfolio that should outperform stock mutual funds in a market that's down, flat or slightly up. While the fund's only been around since mid-2001, the strategy has paid off thus far -- losing a mere 3.5% in 2002.

If you think the market's going to go nowhere for some time, then this Bridgeway fund is a place for your money.

Let's let him explain the rest:

This balanced fund is obviously unusual. Can you explain its basic strategy?


Let's start with the investment objective. We want to produce high current return with less risk and short-term risk less than or equal to 40% of the stock market. That means if the market is up 100 points, we're up 40. If the market goes down 100, we're down 40. The goal is to have a beta of 0.4.

We want a more conservative, lower-volatility portfolio. On the surface that seems complicated, but it's a fairly simple story about managing risk.

What does the fund invest in?


We're combining fixed income, stocks and options. First, at least 25% of the portfolio is in fixed income. That's very straightforward. It's almost entirely in Treasury bills and notes, laddered in a simple structure. The average maturity is about two years. It may not always be exactly that way. But the way it fits into the puzzle, we always have a high degree of quality in this part of the portfolio.

What about the stocks?


We have 75% in equities. That's then split into three parts. Part of the portfolio is indexed, meaning it replicates the S&P 500. Another part invests in value stocks, and the other is in growth stocks. We actively pick those securities with the quantitative models or computer programs used to select stocks at the other Bridgeway funds.

And the options?


Options are the third leg of the stool after bonds and stocks. We write puts as a way to initiate a position in a stock that we don't own. And we write covered calls on stocks we do own to reduce our risk and generate some income, which we get from the premium we're paid for writing the call.

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: The stock is currently trading at $12.40 a share. The May 12.5 puts are priced at 90 cents. So if we sold those puts at 90 cents, we'd be obligated to buy Nextel between now and the May expiration at 12.50; since we took in 90 cents in premium, our true cost basis will be $11.50. We'd only sell puts on a stock we'd want to own.

Of the fund, 45% of the whole portfolio is indexed to the S&P 500. The value and growth picks make up 30% of the fund. The majority of that stock exposure is through direct ownership of the actual stocks. But at the most, we could have written options on up to 40% of the portfolio.

Isn't using options expensive?


In general, options can be expensive. But as a general rule, we're very focused keeping costs down.

Selling puts is cheaper than selling covered calls. You have to pay a commission for both of those options transactions just like you do when you buy or sell a stock. But when you're selling a call, you also have to pay a commission to buy the underlying stock. So it's two commissions vs. one.

How do you keep costs down then?


We try to pay very low commission rates. The average cost of a trade in our funds is a little over a penny a share. We use a wide array of brokers and trading platforms like Instinet. What we've found out: The more trades we do ourselves, the better the execution is.

In other words, if you hand a transaction off to a broker, you'll wind up paying more money. It's not just the commissions. It's also the spread ? the difference in what the buyer is willing to pay and the seller is willing to take. That said, there are some very good brokers out there that we use.

What's the fund's volatility compared with the S&P 500?


It's right on the nose of where we want it to be.

How is the portfolio positioned today vs. say a few months ago?


It's changed very little lately. On the value side of the stocks we pick, we own financial services stocks like J.P. Morgan. On the growth side, we have some technology.

This fund opened in mid-2001 and has done well in the down market of the past couple of years. In the last year, it's beating more than 80% of other balanced or hybrid funds and it's beating the S&P 500's return by more than 15 percentage points. But what happens to this fund in a market that goes up? Will it underperform if the market rises consistently?


By definition it will underperform in a bull market. But some markets are better than others.

Say we have a market that's up 12% in a year. If the market goes up 1 percentage point a month, that's an ideal situation. The puts we've sold will expire worthless.

That means the stocks never fall enough to make it profitable for the buyer of those options to exercise them. They have no value at expiration, but the fund keeps the premium paid when it sold the options.

If the market went up 12% in one month, that's less than ideal. Those puts still expire worthless, and we get to keep the premium income. But the stocks that we've written calls on can be called away. That limits our upside because we would no longer own those stocks. The upside won't be as great. We'd be selling stocks in a market that's going up.

Theoretically 40% of the fund's holdings could get called away, but it's not going to happen like that. You will have some puts and some stocks with no options written against them.

And we have a minimum of 25% of the fund in fixed income, which would hold the fund back when the market goes up.