4th Quarter 2010 Commentary - ASTON/M.D. Sass Enhanced Equity Fund
4th Quarter 2010 Commentary
Year in Review
The past year was a very challenging one for the Fund. Although the portfolio kept pace with the overall market (as measured by the S&P 500 Index) during the first three quarters of the year, the fourth quarter was another story. The Fund lagged the S&P 500 severely in the face of its second consecutive 10% plus quarterly gain. Our practice of selling call options that by their nature truncate the returns on the upside during periods of rapidly rising equity prices served as a drag on returns, as did the portfolio's bias toward large-cap, dividend-paying stocks and a position in S&P 500 put options.
Our strategy of selling out-of-the-money call options helped the Fund to capture a significant portion of the third quarter advance but left very little room to keep pace with the rally through the end of the year. By the fourth quarter, a meaningful percentage of portfolio holdings were trading above the strike prices of the call options sold. In addition, being risk adverse as the market continued to rise we began to buy index put options on the S&P 500 to protect against a potential downside swing, resulting in an additional 100 basis points of negative return.
Dividend-paying large-cap stocks were clearly out of step during the fourth quarter as well, as the market focused on small-cap and commodity-related issuers. For the portfolio to own those types of stocks would have forced us to focus on 2012 estimates, one year further out than we are comfortable using in our valuation analysis. The Fund did have a healthy stake in the Consumer Discretionary sector, which performed well during the period, through stocks such as cruise-line operator Carnival Corporation, Home Depot, and McGraw Hill. Unfortunately, they were also prime examples of where performance exceeded our ability to capture all of the upside as they vaulted through the strike prices of the call options we sold. By year end, the Fund remained overweight traditionally defensive areas of the stock market, namely Utilities, large healthcare firms, and major defense-oriented companies. In addition, the stake in Energy declined to zero as holdings were called away.
The S&P 500 Index does not advance 10% per quarter every quarter, and doing so for two consecutive quarters as it did at the end of 2010 is extremely rare. In a recent commentary that we wrote (available on the Aston website), we discussed the cross currents currently buffeting the economy and the stock market. There was a comment towards the end of that paper that I believe will be a positive for our strategy which is the likely shift in emphasis within the equity areas away from the high octane, small-cap, and commodity-oriented companies towards these that are paying dividends and have the free cash flows to increase those payments over time.
Our view of investing is we would rather be the tortoise than the hare, with a goal of consistent returns over time driven by superior income and appreciation—not one or the other, but both. We believe that hedging the Fund's positions by selling calls on individual holdings and buying put options when they are relatively inexpensive, which we think they are today, is the best way to achieve that goal over the long run. In that regard, we continue to strive to increase the relative yield of the portfolio and lower its overall relative valuation over time.
Senior Portfolio Manager
As of December 31, 2010, Carnival Corporation comprised 0.00% of the portfolio's assets, Home Depot – 2.90%, and McGraw Hill – 2.00%.
Note: By selling covered call options, the Fund limits its opportunity to profit from an increase in the price of the underlying stock above the exercise price, but continues to bear the risk of a decline in the stock. A liquid market may not exist for options held by the Fund. If the Fund is not able to close out an options transaction, it will not be able to sell the underlying security until the option expires or is exercised. While the Fund receives premiums for writing the call options, the price it realizes from the exercise of an option could be substantially below a stock’s current market price. Premiums from the Fund’s sale of call options typically will result in short-term capital gain taxes, making it ill suited for investors seeking a tax efficient investment.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.