Despite some occasional upbeat economic news, it's still hard to ignore just how fragile the U.S. economy is, with an anemic growth rate and stubbornly high unemployment on top of the hobbled real estate market and troubles in Europe.

Third-quarter volatility was just another reminder of how risky equities can be. Many investors are spooked. Just one indication: There is nearly $3 trillion sitting in money-market accounts and CDs.

Yet most fund companies haven't been sitting idly by. Trying to get some of this money off the sidelines, they've introduced a slew of new alternative strategies mutual funds, which promise to give investors downside protection.

Since 2009, Morningstar has tracked 34 new long-short fund launches, which is almost half of the 71 long-short funds in existence. Long-short mutual funds mimic some of the trading strategies hedge funds use - such as leverage, derivatives and short positions - in an attempt to maximize total returns, regardless of market conditions. In 2010, the alternatives category had $18.8 billion in net inflows, far exceeding the $12.7 billion in inflows that the group generated in 2009, according to Morningstar data.

Investors may just now be discovering the charms of funds that seek to protect them from unforgiving markets, but the Gateway Fund has been quietly dampening volatility since its debut in 1977, making it the grande dame of the long-short category.

"What we're trying to do is offer an investment that's a combination of equity market exposure and risk management," says Michael Buckius, who manages the fund with J. Patrick Rogers and Paul Stewart. The fund shoots for a beta that's between 35% and 40%.

As a result, Gateway tends to have a risk profile similar to intermediate- to long-term bonds, while also participating in some of the equity market upside. Gateway's long history has helped to position it as one of the largest alternative investment offerings around, with assets of $5.2 billion.

For the three years ended Nov. 4, Gateway is up 3.2% a year annualized, in the top 52% of long-short funds, according to Morningstar. For the five-year period, it's up 1.1% a year annualized, in the category's top 31%, according to Morningstar.


Hedging is invariably technical, and it's no different at the Gateway Fund. The managers use a three-pronged approach that combines upside potential with downside protection.

First the fund starts with a basket of 275 to 400 individual securities that carry a risk-reward profile similar to the S&P 500. The fund doesn't own each of the names in the index, just a representative sample. "We don't need all 500 stocks to get our equity exposure," Buckius says. Gateway rarely moves in and out of these stocks, which helps keep taxes under control.

Next, Gateway sells call options on the S&P 500 near the index's current value and with expiration dates in the not-too-distant future. Gateway generates cash flow from selling these options - the main source of the fund's upside returns - more than the appreciation on its stocks.

If the S&P 500 goes down, the fund's options income helps offset declines from the index. If the S&P rises, the fund goes up much less because options buyers will demand stocks at prices below the now-higher value of the index.

Finally, Gateway buys index puts with strike prices 6% to 10% below the S&P 500. Some investors use puts to bet that prices will fall, but Gateway isn't trying to speculate.

The fund uses puts as portfolio insurance against declines. "We're willing to take a portion of the regular cash flow and spend that to buy downside protection," Buckius says.


Gateway's strategy works best when markets are roiling and investors are heading for the exits. For example, in 2008, the fund fell 13.9%, while the S&P 500 plunged 37%. Since its inception, Gateway has only logged four negative years, including 2008.

Yet a fund like Gateway doesn't take advantage of a falling market to rack up outsize gains. "We're not bearish," Buckius says. "We would prefer that years like 2008 didn't happen, so we are not positioning ourselves to make money in those types of markets."

Likewise, Gateway was only nicked in the third quarter of this year, down 4.8%, while the S&P 500 was dented 13.9% and the category dropped an average of 8.5%. The fund behaved similarly during the Flash Crash in May 2010.


But when markets are rebounding, Gateway looks like an also-ran. "We lag in a strong upmarket on a relative basis," Buckius acknowledges. "The benefit to investors, however, is that we have a positive absolute return when that happens."

The fund has muddled along since the market bottom of 2009, recent performance notwithstanding. That's to be expected; call options limit the amount of gains that the stocks in the Gateway portfolio can generate. But Buckius points out that the less a fund loses in terrible markets, the less it has to make up during rebounds to generate decent returns.

The increased volatility of recent times has also led Gateway to stumble. There has been a breakdown in the relationship between expected volatility, as measured by the VIX Index, and the realized volatility of the S&P 500 itself.

Normally, call options (which are priced based on expected volatility) make money for the fund when they're short. Put options, meanwhile, were relatively cheap to buy. But the financial crisis of 2008 changed many of these relationships.

"When realized volatility spikes, it's no longer profitable to write covered calls. And the puts are costing more," says Nadia Papagiannis, director of alternative fund research at Morningstar. "This fund probably hasn't provided as much upside as investors might like."

Gateway has also struggled recently because unlike most other funds in its category, Gateway doesn't make individual stock selections it buys long or sells short. Its initial basket of stocks is chosen for its index-mimicking characteristics, not its potential to generate return, so Gateway doesn't have opportunities to seek out mispriced securities. Papagiannis notes that Gateway has gone through other periods where its strategy was out of favor and it has not veered from it.



It's hard to say whether investors must accept erratic markets as the "new normal," Buckius says, even though that has been the case over the past few years. Gateway can protect its shareholders against unusually jarring spikes in either direction, but there's no guarantee that's what the markets will bring.

Buckius sees a protracted period of deleveraging that is likely to mute equity returns for years to come. That process, he says, could take seven to nine years to unfold, and we're only a few years into it.

"It's a longer process than a recession," he says. "That's made risk management much more of a focus for investors, but I don't think it's permanently changed the nature of markets or equities."

Ilana Polyak, a New York writer who contributes regularly to Financial Planning, has written for The New York Times, Money and Kiplinger's.


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