Please give to The Capital Times Kids Fund.

Confessions of a Money Manager: Market's roller coaster ride perplexes investors

Ray Unger  —  8/07/2008 5:08 pm

Whew, what a ride! Lately the stock market's had more topsy-turvy turns, sudden drops and sharp rises than a Disney roller coaster ride. It's been a Big Thunder Mountain experience channeling through dark caves and scary mountain passes that keeps riders guessing what's next.

Take Tuesday's trading session. After the Federal Reserve decided to do nothing -- keeping interest rates the same -- the market explodes, jumping 331 points on the Dow. Such a three-digit up move is a pleasant relief from the disheartening losses in the past two weeks. Since July 24, the Dow has lost more than 200 points in three separate trading sessions. That's got to be some sort of record.

Of course, momentous trading sessions follow momentous economic events. When's the last time the financial giants of the world hemorrhaged billions of dollars of losses? Or when's the last time oil prices ballooned to $147 a barrel?

Nonetheless investors, especially those close to retirement, can't help but wonder how to deal with such volatility. Should they exit the market all together and hope for the best in fixed-income investments that pay paltry returns? Or should they just suck up the consternation these swings bring and hope better times are ahead? For many investors the volatility is just too much so they opt out of stocks completely. Well, there is a third way.

We'll need a few definitions before we launch into buying low-risk common stock alternatives. The first word is Beta. Beta refers to how volatile a stock or mutual fund is relative to the overall stock market, like the Standard & Poor's 500. If the investment moves in perfect tandem with the S&P 500, the Beta is 1. If the investment's volatility is greater than the S&P 500 the Beta is greater than 1, and conversely, if the investment's volatility is less than the S&P 500 the Beta is less than 1.

Alpha is the second word. Alpha refers to how a stock or mutual fund performs when the S&P 500 is dead flat. If the Alpha is positive, that means the investment has a positive return when the market is flat. If the Alpha is negative, the investment is generally negative when the S&P 500 is flat.

Those two statistical terms now allow us to speak about potential risk and volatility. Investors who think the market's going up invest in high Beta stocks or mutual funds. Those who think the market's going to fall invest in high Alpha stocks or mutual funds. But what about those who just want to participate in the market, but want less volatility? Now we're getting to the nitty-gritty of avoiding the roller coaster swings of the market.

One of my favorite mutual funds that participates in the stock market yet doesn't give investors apoplexy when the market swoons is the Gateway Fund (GATEX $28.19). Now that we've discussed Alpha and Beta, let me provide these statistical risk measures to Gateway. According to Yahoo Finance, Gateway's Alpha over the last 10 years was 1.73 percent. That means when the market is unchanged, the Gateway fund showed a modest gain. Its Beta, however, was only 0.4 of 1.0 percent. That means it was much less volatile than the S&P 500.

How does this translate into raw performance? As a matter of fact, these statistics have been born out by quite impressive risk-adjusted returns. Gateway's worst performing year was in 1987 when it lost 5.65 percent. During the bear market of 2000-02, it lost 3.53 percent in 2001, and 4.86 percent in 2002. That's remarkable performance during the worst bear market since the Great Depression.

On the upside, Gateway has averaged 6.56 percent over the last five years, and 4.70 percent over the last 10 years, which again, included the 2000-02 bear market.

What's Gateway's strategy? Gateway employs a rather simple and straightforward approach. The core of the fund consists of large-cap common stocks that perform similarly to the S&P 500, but hedge the portfolio by selling index call options on the S&P 500. These options bring in income and also cushion the fund when the S&P 500 falls. They hinder the fund when the S&P 500 rises, but that's the reason the fund's Beta is so low.

Consistent with these performance metrics, Gateway's year-to-date performance is up fractionally while the S&P 500 is off 12.2 percent. For investors who need modest appreciation but don't want the volatility, Gateway is a merry-go-round compared to the S&P 500's roller coaster.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400.

Ray Unger  —  8/07/2008 5:08 pm