RiverNorth Managed Volatility Fund (RNBWX) – December 2012

Objective and Strategy

The fund seeks to provide investors with total return comparable over time to that of the S&P500, with substantially lower volatility. They seek to achieve that end by investing in U.S. exchange-listed equity options, equities and ETFs. Typically the securities and options will focus on firms similar in size and liquidity to those in the S&P 500, but the manager also has the freedom to invest in smaller cap names and U.S.-traded foreign stocks (typically through ADRs). The manager selects securities based primarily on his view of opportunities in the options market with a secondary focus on opportunities presented by the underlying stocks themselves.

Adviser

RiverNorth Capital Management, LLC. RiverNorth, founded in 2000, specializes in quantitative and qualitative closed-end fund trading strategies and advises the RiverNorth Core Opportunity (RNCOX), RiverNorth/DoubleLine Strategic Income (RNDLX) RiverNorth/Manning & Napier Dividend Income (RNMNX), the forthcoming RiverNorth/OakTree High Income funds and several hedge funds. They managed $2.1 billion, as of 9/30/12.

Manager

Eric Metz, CFA. Mr. Metz joined RiverNorth in 2012 and serves as Portfolio Manager and Derivatives Strategist. Prior to joining RiverNorth, Eric was a partner at Bengal Capital LLC and senior trader at Ronin Capital, LLC. He has several Industrial and Operations Engineering degrees from the University of Michigan and eight monitors at his work-station. (The more tech-focused members of the Observer staff are insanely jealous.)

Management’s Stake in the Fund

None yet disclosed, but the RiverNorth folks report that as of mid-November, most of the fund’s assets came from the Adviser, other investment advisors who have made allocations to other RiverNorth strategies and from the portfolio manager and other RiverNorth professionals.

Opening date

October 12, 2012

Minimum investment

$5,000 for regular accounts, $1,000 for IRAs.

Expense ratio

1.80%, after waivers, on assets of $7.8 million.

Comments

It’s a lot like cricket.

I’m sure I could learn to appreciate cricket, if only it didn’t seem impenetrably bizarre. The commentary on a match between South Africa and Australia (12/1/12) begins:

Day one of the third Test of this enthralling series had plenty of excitement – a South African batting collapse that saw the Proteas bowled out for just 225 and some nervous late moments for Australia, which finished the day at 2/33.

All eyes today on Ricky Ponting, who likely make an early appearance with the bat in his 168th and final Test.

This might be the second or third most-popular sport on the planet, and I’m hesitant to even approach it because of the complexity of figuring out what’s going on and the prospect that I’ll look like a fool in the interim. That’s about the way a lot of investors and advisers feel in approached an options-based portfolio strategy.

RiverNorth Dynamic Buy-Write will pursue an active form of a perfectly sensible strategy that typically manages to deliver almost all of the stock market’s returns with a fraction of its volatility. It’s called a covered call strategy.

Here’s the rudimentary version of the strategy: an investor who owns shares of a stock might choose to sell to a second investor the right to buy those shares at an agreed-upon price. For example, you might own shares of Apple that are selling at $585 and you sell me the option of buying those shares of $600 a piece at any time in the next three months. Even if those shares are selling at $650 two months from now, I get to buy them from you for $600. But in order to buy that option, I need to pay you a monthly premium. That premium can be pretty substantial: perhaps 1.8% per month.

So, in our example, if Apple goes to $599 over the next three months, you keep the stock, pocket the gains and pocket my premiums on the unexercised option. If the stock goes to $650, you sell the stock me at $600, you pocket a gain on the sale of the stock and you pocket my premiums. If the stock falls, you can keep the shares or sell them but you still pocket the premium.

The strategy quickly becomes much more complicated than that but, in truth, I don’t think either of us needs to choke on the details.

This strategy is used by many high net worth investors but only a few mutual funds, despite the fact that there’s almost universal agreement that over the past quarter century the strategy, as manifested in the CBOE S&P 500 BuyWrite Index (BXM):

    • Outperformed the S&P 500 overall, returning 830% to the S&P’s 807%.
    • Produced those returns with 30% less volatility than the S&P.
    • Had a much smaller maximum draw-down (that is, the loss measured from the index’s peak to its subsequent trough).
    • Generated a lot of income (typically 1.8%/month) from premium, in general premiums rise as volatility does so that your downside protection tends to increase when you most need it.
    • Had better risk-adjusted returns, as measured by Sortino and Sharpe ratios.

That pattern is stable across time: the half-dozen studies I’ve reviewed each covered different time frames and time periods (some five year studies, some ten, some 14, some 25, some ending in 2003, others in 2006 or 2011) and yet they all found the same thing: a covered call strategy generates returns competitive with the stock market’s but with substantially less downside.

Here’s one visual representation of that relationship, drawn from RiverNorth’s fund materials:

RiverNorth Managed Volatility Fund (RNBWX)   December 2012

This is a very good deal for investors. RiverNorth believes they can make it better. They believe that option pricing can be inefficient or at least less efficient than the stock market; that options can be noticeably mispriced, if only for short periods. The manager believes that he can post results that are north and west of the blue BXM diamond; that is, returns that are some combination of higher and less volatile than the index’s. He believes he has three strategies that will allow him to beat the BXM index:

They’ll build the portfolio based on their assessment of the most attractive options (where they do have a competitive advantage), rather than on assessments of the underlying stocks.

They’ll actively manage the portfolio, rather than just holding stocks and selling a single set of options on them.

They’ll actively manage beta. They’re looking for a consistent target beta between 0.2 and 0.5; that is, they want their portfolio to show between 20-50% of the market’s volatility. If volatility rises above that range, they’ll work to trade risk down but, conversely, if beta is dropping too low they’ll add risk to the portfolio in order to maximize alpha.

Can they pull it off? While the fund is, at this writing, just six weeks old, there are three reasons to be optimistic.

RiverNorth gets it right: this is a firm with a strong record of finding unique opportunities and successfully exploiting them, while still remaining focused on the needs of their shareholders.

Mr. Metz appears to be capable and experienced: he has been successfully executing options-based strategies for several reputable firms, including two proprietary trading firms and a large family-based hedge fund, for approximately a decade.

The fund is outperforming the index, day by day. We looked at the daily returns of RNBWX, the S&P 500, BXM and Gateway fund (GATEX), the 700-pound gorilla among covered call funds. We found that:

      • RNBWX had the highest overall return.
      • On days when the market was rising, RNBWX captured about one-third of the market’s gain which was a bit weaker than Gateway or BXM.
      • On days when the market was falling, RNBWX dropped only one-third as much as the BXM, barely one quarter of the market’s fall and a bit over half of Gateway’s fall.
      • On days when the market was falling sharply (by more than 1% in a single day), RNBWX dramatically outperformed all three of the others.

Here’s the overall picture of performance:

RiverNorth Managed Volatility Fund (RNBWX)   December 2012

So far, anyway, RNBWX has outperformed the S&P, its largest competitor and its benchmark index and has done so with less volatility.

Bottom Line

The evidence is incontrovertible. This strategy works, works over time and works in a variety of different market conditions. Investors, who are concerned about volatility and who are unconvinced (as I am) that it’s wise to load up on bonds, should look carefully at it. If you want to pursue a purely passive strategy, there is one ETF (S&P 500 BuyWrite Portfolio ETF, PBP) and one ETN (CBOE S&P 500 BuyWrite Index ETN, BWV) in which to invest. If you believe, as RiverNorth does, that the options market presents exploitable inefficiencies, then active management might produce substantially stronger results than passive. And few active management teams seem better-positioned than RiverNorth to take advantage of those opportunities.

Fund website

RiverNorth Dynamic Buy-Write

Investors interested in looking more closely at the underlying strategy, as manifested in the Buy-Write Index have a wealth of published research that they might peruse. The good news: (1) the research is easily available and (2) remarkably consistent in its findings. The bad news: only a masochist with a doctorate in statistics will really enjoy working through this stuff. The most accessible of them, for a bright non-specialist, might be the Asset Consulting Group’s “An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns” (2012) which contains lots of straightforward comparisons of the risks and returns of the S&P500 and BXM (among other indexes) for a variety of time periods. Slightly denser reviews include Hewitt EnnissKnupp’s The CBOE S&P 500 BuyWrite Index (BXM): A Review of Performance (2012) and Ibbottson’s, Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index (2004).

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© Mutual Fund Observer, 2012. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact [email protected]
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