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TCW/Gargoyle Hedged Value, September 2015

By David Objective and strategy TCW/Gargoyle Hedged Value seeks long-term capital appreciation while exposing investors to less risk than broad stock market indices. The strategy is to hold a diversified portfolio mid- to large-cap value stocks, mostly domestic, and to hedge part of the stock market risk by selling a blend of index call options. In theory, the mix will allow investors to enjoy most of the market’s upside while being buffered for a fair chunk of its downside. Adviser TCW. TCW, based in Los Angeles, was founded in 1971 as Trust Company of the West. About $140 billion of that are in fixed income assets. The Carlyle Group owns about 60% of the adviser while TCW’s employees own the remainder. They advise 22 TCW funds, as well as nine Metropolitan West funds with a new series of TCW Alternative funds in registration. As of June 30, 2015, the firm had about $180 billion in AUM; of that, $18 billion resides in TCW funds and $76 billion in the mostly fixed-income MetWest funds. Manager Joshua B. Parker and Alan Salzbank. Messrs. Parker and Salzbank are the Managing Partners of Gargoyle Investment Advisor, LLC. They were the architects of the combined strategy and managed the hedge fund which became RiverPark/Gargoyle, and now TCW/Gargoyle, and also oversee about a half billion in separate accounts. Mr. Parker, a securities lawyer by training is also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They both have over three decades of experience and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Strategy capacity and closure The managers estimate that they could manage about $2 billion in the stock portion of the portfolio and a vastly greater sum in the large, liquid options market. TCW appears not to have any clear standards controlling fund closures. Active share “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Gargoyle has calculated the active share of the equity portion of the portfolio but is legally constrained from making that information public. Given the portfolio’s distinctive construction, it’s apt to be reasonably high. Management’s stake in the fund As of January 2014, the managers had $5 million invested in the strategy (including $500,000 in this fund). Gargoyle Partners and employees have over $10 million invested in the strategy. Opening date The strategy was originally embodied in a hedge fund which launched December 31, 1999. The hedge fund converted to a mutual fund on April 30, 2012. TCW adopted the RiverPark fund on June 26, 2015. Minimum investment $5000, reduced to $1000 for retirement accounts. There’s also an institutional share class (MUTF: TFHIX ) with a $1 million minimum and 1.25% expense ratio. Expense ratio 1.50%, after waivers, on assets of $74.5 million, as of July 2015. Comments Shakespeare was right. Juliet, the world’s most famously confused 13-year-old, decries the harm that a name can do: ‘Tis but thy name that is my enemy; Thou art thyself, though not a Montague. What’s Montague? it is nor hand, nor foot, Nor arm, nor face, nor any other part Belonging to a man. O, be some other name! What’s in a name? that which we call a rose By any other name would smell as sweet; So Romeo would, were he not Romeo call’d, Retain that dear perfection which he owes Without that title. Her point is clear: people react to the name, no matter how little sense that makes. In many ways, they make the same mistake with this fund. The word “hedged” as the first significant term of the name leads many people to think “low volatility,” “mild-mannered,” “market neutral” or something comparable. Those who understand the fund’s strategy recognize that it isn’t any of those things. The Gargoyle fund has two components. The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month. The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (price to book, earnings, cash flow and sales) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the hundred most undervalued stocks, but maintain sector weightings that are close to the S&P 500’s. The options portfolio is index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums. Why index calls? Two reasons: (1) they are systematically mispriced, and so they generate more profit (or suffer less of a loss) than they theoretically should. Apparently, anxious investors are not as price sensitive as they should be. In particular, these options are overpriced by about 35 basis points per month 88% of the time. For sellers such as Gargoyle, that means something like a 35 bps free lunch. Moreover, (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their stock-specific upside. By managing their options overlay, the team can react to changes in the extent to which their investors are exposed to the stock markets movements. At base, as they sell more index options, they reduce the degree to which the fund is exposed to the market. Their plan is to keep net market exposure somewhere in the range of 35-65%, with a 50% average and a healthy amount of income. On whole, the strategy works. The entire strategy has outperformed the S&P. Since inception, its returns have roughly doubled those of the S&P 500. It’s done so with modestly less volatility. Throughout, it has sort of clubbed its actively-managed long-short peers. More significantly, it has substantially outperformed the gargantuan Gateway Fund (MUTF: GATEX ). At $7.8 billion, Gateway is – for many institutions and advisors – the automatic go-to fund for an options-hedged portfolio. It’s not clear to me that it should be. Here’s the long-term performance of Gateway (green) versus Gargoyle (blue): Two things stand out: an initial investment in Gargoyle fifteen years ago would have returned more than twice as much as the same investment at the same time in Gateway (or the S&P 500). That outperformance is neither a fluke nor a one-time occurrence: Gargoyle leads Gateway over the past one, three, five, seven and ten-year periods as well. The second thing that stands out is Gargoyle’s weak performance in the 2008 crash. The fund’s maximum drawdown was 48%, between 10/07 and 03/09. The managers attribute that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback came in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%. The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble. Morty Schaja, president of River Park Funds, notes that “We are going to have meltdowns in the future, but it is unlikely that they will play out the same way as it did 2008 . . . a market decline that is substantial but lasts a long time, would play better for Gargoyle that sells 1-2% option premium and therefore has that as a cushion every month as compared to a sudden drop in one quarter where they are more exposed. Similarly, a market decline that experiences movement from growth stocks to value stocks would benefit a Gargoyle, as compared to a 2008.” I concur. Just as the French obsession with avoiding a repeat of WW1 led to the disastrous decision to build the Maginot Line in the 1930s, so an investor’s obsession with avoiding “another ’08” will lead him badly astray. What about the ETF option? Josh and Alan anticipate clubbing the emerging bevy of buy-write ETFs. The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month. There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000 and 2012, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P. Nonetheless, investors need to know that returns are lumpy; it’s quite capable of beating the S&P 500 for three or four years in a row, and then trailing it for the next three or four. The fund’s returns are not highly correlated with the returns of the S&P 500; the fund may lose money when the index makes money, and vice versa. That’s true in the short term – it beat the S&P 500 during August’s turbulence but substantially trailed during the quieter July – as well as the long-term. All of that is driven by the fact that this is a fairly aggressive value portfolio. In years when value investing is out of favor and momentum rules the day, the fund will lag. Bottom line On average and over time, a value-oriented portfolio works. It outperforms growth-oriented portfolios and generally does so with lower volatility. On average and over time, an options overlay works and an actively-managed one works better. It generates substantial income and effectively buffers market volatility with modest loss of upside potential. There will always be periods, such as the rapidly rising market of the past several years, where their performance is merely solid rather than spectacular. That said, Messrs. Parker and Salzbank have been doing this and doing this well for decades. What’s the role of the fund in a portfolio? For the guys, it’s virtually 100% of their US equity exposure. In talking with investors, they discuss it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. Indeed, the record suggests “very profitably.”

Manning & Napier Pro-Blend Conservative Term Series S, September 2015

Objective and strategy The fund’s first objective is preservation of capital. Its secondary concerns are to provide income and long-term growth of capital. The fund invests primarily in fixed-income securities. It tilts toward shorter-term, investment grade issues, while having the ability to go elsewhere when the opportunities are compelling. It also invests in foreign and domestic stocks, with a preference for dividend-paying equities. Finally, it may invest a bit in a managed futures strategy as a hedge. In general, though, bonds are 55-85% of the portfolio. In the past five years, stocks have accounted for 25-35% of the portfolio, though they might be about 10% higher or lower if conditions warrant. Adviser Manning & Napier (NYSE: MN ). Manning & Napier was founded in 1970 by Bill Manning and Bill Napier. They’re headquartered near Rochester, NY, with offices in Columbus, OH, Chicago and St. Petersburg. They serve a diversified client base of high-net worth individuals and institutions, including 401(k) plans, pension plans, Taft-Hartley plans, endowments and foundations. It’s a publicly traded company with $43 billion in assets under management. Of that, about $18 billion are in their team-managed mutual funds and the remainder in a series of separately managed accounts. Manager The fund is managed by a seven-person team headed by Jeffrey Herrmann and Marc Tommasi. Both of them have been with the fund since its launch. The same team manages all of Manning & Napier’s Pro-Blend and Target Date funds. Management’s stake in the fund We generally look for funds where the managers have placed a lot of their own money to work beside yours. The managers work as a team on about 10 funds. While few of them have any investment in this particular fund, virtually all have large investments between the various Pro-Blend and Lifestyle funds. Opening date November 1, 1995. Minimum investment $2,000. That is reduced to $25 if you sign up for an automatic monthly investing plan. Expense ratio 0.87% on $1.5 billion in assets as of August 2015. That’s about average for funds of this type. Comments Pro-Blend Conservative offers many of the same attractions as the Vanguard STAR Fund (MUTF: VGSTX ), but does so with a more conservative asset allocation. Here are three arguments on its behalf. First, the fund invests in a way that is broadly diversified and pretty conservative . The portfolio holds something like 200 stocks and 500 bonds, plus a few dozen other holdings. Collectively, those represent perhaps 25 different asset classes. No stock position occupies as much as 1% of the portfolio, and it currently has much less direct foreign investment than its peers. Second, Manning & Napier is very good . The firm does lots of things right, and they’ve been doing it right for a long while. Their funds are all team-managed, which tends to produce more consistent, risk-conscious decisions. Their staff’s bonuses are tied to the firm’s goal of absolute returns, so if investors lose money, the analysts suffer too. The management teams are long-tenured – as with this fund, 20-year stints are not uncommon – and most managers have substantial investments alongside yours. Third, Pro-Blend Conservative works . Their strategy is to make money by not losing money. That helps explain a paradoxical finding: they might make only half as much as the stock market in a good year, but they managed to outperform the stock market over the past 15. Why? Because they haven’t had to dig themselves out of deep holes first. The longer a bull market goes on, the less obvious that advantage is. But once the market turns choppy, it reasserts itself. At the same time, the fund has the ability to become more aggressive when conditions warrant. It just does so carefully. Chris Petrosino, one of the managing directors at Manning, explained it this way: We have the ability to be more aggressive. For us, that’s based on current market conditions, fundamentals, pricing and valuations. It may appear contrarian, but valuations dictate our actions. We use those valuations that we see in various asset classes (not only in equities), as our road map. We use our flexibility to invest where we see opportunities, which means that our portfolio often looks very different than the benchmark. Bottom Line The Pro-Blend Conservative Term Series S Fund has been a fine performer since launch. It has returned over 6% since launch and 5.4% annually over the past 15 years. That’s about 1% per year better than the total stock market and its conservative peers. In general, the fund has managed to make between 4-5% each year; more importantly, it has made money for its investors in 19 of the past 20 years. It is an outstanding first choice for cautious investors.

401(k) Fund Spotlight: AllianzGI NFJ Small-Cap Value Fund

Summary PCVAX’s performance is hampered by its large size. PCVAX has consistently lagged the comparable Russell 2000 Value Index. An examination of the last 2 recessionary periods reveals that PCVAX tends to outperform broader small cap indexes during bear market periods. I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. The AllianzGI NFJ Small-Cap Value Fund The AllianzGI NFJ Small-Cap Value Fund has the following share classes: The net expense ratios for the share classes range from a low of .73% (R-6 shares) to a high of 1.93% (C shares). If the fund is in your 401(k), it is most likely in the form of the A shares (load waived), which have a net expense ratio of 1.18%. For the purposes of this article, I will assume the A shares are the available option and evaluate the fund based on the 1.18% expense ratio. I will use the ticker PCVAX to represent the fund name throughout the article. Fund Size Has Implications PCVAX invests in small cap companies that its managers believe are undervalued, with an emphasis on those paying dividends. The fund focuses on the universe of small cap companies with total market caps ranging from $100 million to $3.5 billion. With a little over $6 billion of total assets, the fund is one of the largest in its category. The average market cap of its 135 holdings is $2.7 billion. This has several important implications. First, the fund has to hold a lot of different stocks in order to have most of its assets invested. Otherwise, if it were to have a more concentrated portfolio (i.e., fewer stocks), it would have substantial ownership interests in these few companies. For example, to invest $6 billion in 50 companies would mean that, on average, a fund would have a $120 million stake in each company. This would mean a stake of 5% to 20% in many of the companies. This would give the investment company a lot more control-and responsibility-as it relates to those companies. My view is that there is nothing wrong with a concentrated portfolio. Indeed, I prefer it, because it would show me they know the companies so well that they are willing to make serious commitments. Sadly, most of the funds in the mutual fund industry have devolved into quasi-index funds with higher expense ratios. The industry’s entrepreneurial investment ambition died off a long time ago and it has been replaced with herd-like complacency. Second, because of this first implication, the fund has to hold a lot more stocks. The more stocks the fund owns, the closer it gets to mirroring the index. It is hard for a large, small cap fund to not be an index hugger. Third, again because of the first implication, it is very difficult for the overall fund to generate enhanced returns from investing in smaller, more unknown small caps that generate exceptional returns. The stocks are just too small to make a major difference to the fund’s overall performance. Performance There are several ways to evaluate the performance of PCVAX. Let us start by taking a look at its comparable index, the Russell 2000 Value Index, which focuses on 2,000 small capitalization (“cap”) stocks with a value orientation. In the following two charts I use the iShares Russell 2000 Value ETF (NYSEARCA: IWN ) as a proxy for the index: PCVAX Total Return Price data by YCharts PCVAX Total Return Price data by YCharts PCVAX lagged the index by more than 5% over the last 12 months and by 11.8% over the last 5 years. Most 401(k) plan participants usually do not have more than a handful of small cap focused funds to choose from (and sometimes just one or even none). If your plan has PCVAX it might also have a general small cap index fund, such as a Russell 2000 index fund, as another option. The following chart shows how the fund has fared against the iShares Russell 2000 ETF (NYSEARCA: IWM ), a proxy for the Russell 2000 index, over the last 5 years. PCVAX Total Return Price data by YCharts The Russell 2000 index has substantially outpaced PCVAX over the last 5 years. However, before you click over to your 401(k) to make an exchange. Consider the following chart: PCVAX Total Return Price data by YCharts PCVAX substantially outpaced the Russell 2000 index (using IWM proxy) during the 2007 to 2009 period that was marred by the global financial crisis and a deep recession. The value nature of PCVAX and its higher dividend yield (2.6% vs 1.7% for the Russell 2000) means it tends to outperform during periods of weaker overall stock market performance. To take this further, let’s also look at the performance of the two during the previous recessionary, bear market period of 2000 to 2002. The following chart is telling: PCVAX Total Return Price data by YCharts The performance of PCVAX utterly destroyed that of the broader Russell 2000 Index during the 2000 to 2002 time period. The fund’s investment objective also caused it to avoid many of the high flying, and wildly overvalued, small cap technology stocks on the NASDAQ. Not only did it outperform, but the fund kept cruising along in a bullish trend despite the collapsing of the technology bubble. Clearly, the value nature of the fund has some merits during recessionary, bear market periods. Conclusion PCVAX does not have any individual holdings that make up more than 2% of the fund. The performance of the fund will largely mirror that of its comparable index, the Russell 2000 Value index. Given a choice only between the two, investors may want to choose the latter, which has also outperformed PCVAX over the last 1 and 5-year periods. The lower expenses of the index also provide a constant tailwind for better performance. My stock market forecast calls for the broader U.S. market to continue to move sideways over the next two years before finally dipping lower (e.g., -5% to -15%) in the third year. Consequently, this may be a setup for a period when PCVAX, and perhaps small cap value in general, once again outperforms the broader small cap index. Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to American’s within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.