2nd Quarter 2011 Commentary
Equity markets gyrated back and forth within a large trading range during the second quarter of 2011, with the S&P 500 Index moving up and down in covering 100 points. What was surprising, and frustrating for us, was the narrow range of the Options Exchange Market Volatility Index (“VIX”) during the past several months. We would have expected that index to increase much more than it did on each decline in the market. It remained at a low level, in aggregate, however. We believe this persistently low reading on the VIX suggested an underlying optimism on the part of the investors, who as a whole shied away from buying put option protection. This equanimity resulted in a drag on the Fund's performance from the portfolio's defensive put positions, which we view as the defensive aspect of our strategy. As a result, the Fund's performance ended the quarter slightly down, marginally behind the S&P 500.
We remain committed to what we consider to be a low volatility portfolio in part because the equities that we view as undervalued are currently the higher-yielding, larger-capitalization companies that historically and statistically have also been considered lower-volatility stocks. The portfolio is heavily weighted toward traditionally defensive non-cyclical companies, such as Healthcare and Utilities, and underweight commodity oriented companies. In addition, we continue to sell out-of-the-money call options to generate incremental cash.
In our opinion, this is not the time to switch gears and become more aggressive for a variety of reasons. Our fundamental and valuation disciplines strongly suggest that we remain committed to the lower volatility segments of the market with the exception of a few technology companies. Even there, holdings such as Intel and Microsoft had higher than market dividend yields and were selling at a below market price/earnings ratios at the end of the quarter.
Although, we do not manage the portfolio from a top down point of view the current environment is such that we feel compelled to offer our opinion on the major domestic and global events that could shape the investment picture over the foreseeable future. In that regard, we are of the belief that staying the course and being risk adverse will prove to be correct. Given all the uncertainties that are present here, in Europe, and elsewhere we are as convinced as ever that a commitment to a risk mitigation approach will prove most beneficial.
Trees do not grow to the sky and the stock market is unlikely to keep going up at the rate it has for the past two-plus years unless the economy grows at a rate fast enough to sustain double-digit profit increases. We believe the period of earnings growth in excess of 10% per year is unsustainable given the myriad of problems faced by the U.S., Europe, and Japan—problems, by the way, that will likely impact China and India. Financial strains are expected to eventually impact final demand in the mature economies which will affect the rapidly developing regions that rely on those mature regions as consumers of their goods.
Despite the turmoil of the past several years there are still major problems in this country that could result in a prolonged period of low growth. Extremely high levels of debt on the part of every segment of government—Federal, State, and Local—represent a potential drag on economic growth for many years. Every solution that has been enacted and those that are proposed represent financial restraint. If we lower our deficit by reducing expenses it means firing workers. Raising taxes will not work at this juncture as it will undermine business confidence. We are, it appears, between the proverbial rock and a hard place.
Europe is also in a Catch-22 situation in that those countries that lived beyond their means are so far in debt that any austerity program is unlikely to work. Social obligations are not easy to fix if it means benefits must be reduced. Taxes going up only exacerbate the pain of the average citizen, leading to potential social unrest, while debt forgiveness could result in a significant capital shortfall for the banks that hold the debt of the countries that cannot pay. Credit markets are already signaling a likely default based upon the spread and the price of the credit default swaps. In the end, European growth is likely to be extremely low for a protracted period of time.
Furthermore, high oil prices act like a tax to the average consumer, which inevitably causes retail sales of other goods to slow. This problem is often compounded by the desire to maintain profits on the part of the integrated oil companies, as they hold refined product prices high in order to maintain profit margins.
Back in the U.S., the current debt ceiling negotiations are clearly underscoring the difficult situation the federal government finds itself in. The more this plays out in the media, the more it may be viewed as a negative by the average consumer in this country. None of this encourages companies to invest in people or equipment. The senior management teams of major companies seem to acting as one of the most risk adverse groups today.
Given all of these storm clouds, this is not the time in our opinion to disregard the macroeconomic environment. It is difficult to generate a great deal of confidence in earnings beyond this year, and we possibly face the prospect of a reduction in estimates as the balance of this year unfolds. If profits begin to slow, we believe equity valuations would come under serious downward pressure.
Thus, we remain committed to a strategy focused on dampening potential volatility through the use of options and dividend-paying stocks.
Senior Portfolio Manager
As of June 30, 2011, long-only positions in Intel comprised 3.46% of the portfolio's assets and Microsoft – 3.72%.
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. The use of derivatives by the Fund to hedge risk may reduce the opportunity for gain by offsetting the positive effect of favorable price movements. There is no guarantee that derivatives, to the extent employed, will have the intended effect, and their use could cause lower returns or even losses to the Fund.
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.