- The Easterly Hedged Equity Fund (JDIEX) generated a 5.48% return in Q4 vs. 7.56% for the S&P 500. For 2022, JDIEX returned -2.75%, while the SPX declined 18.11%, producing an excess return of 15.36%.
- Despite the conflict between potentially waning inflation and FED hawkishness, equities rallied in Q4, and levels of volatility exhibited their traditional end of the year seasonality dropping from the 32 level to just under 22.
- While the VIX did drop through the quarter, it remains elevated versus the longer-term average and provides ample fuel to our call premium to fund the defensive put spreads we use to protect downside effectively, as well as providing daily income to the fund.
- In 2023 we expect volatility to remain somewhat elevated in the 18-30 range.
- We expect interest rate policy to remain tight for the foreseeable future with a fed funds rate of 5.25% by Q2; investors looking to solely diversify with interest rate-based allocations could be disappointed, as they were in 2022.
- The lagged impacts of monetary policy and the potential that inflation may be stickier than anticipated, could create a meaningful economic slowdown in in the US starting early in 2023.
JDIEX can serve as a good diversifier during periods of volatility. The Fund tends to have higher returns over time than fixed income investments, thus investors can benefit from allocations to JDIEX.
The post Covid inflationary concerns continue to be the major issue for 2023. The implications of a hawkish and vigilant Fed that led to increased volatility in 2022 remain very much in place for 2023. The lagged impacts of monetary policy and the potential that inflation may prove stickier than many had anticipated, may create a meaningful slowdown in economic behavior in the U.S. starting early in 2023. Whether the U.S. will experience a full-fledged or moderate recession remains a bit unclear and will depend on the degree to which the post Covid labor squeeze remains in place. We see the Fed continuing to hike rates, albeit at a slightly slower pace, toward a 5.25% fed funds rate by Q2 2023. Potentially more impactful is the Fed’s continuing balance sheet reduction (QT) well into 2025 that makes liquidity across the capital markets more valuable and helps raise expected volatility across stocks, bonds, currencies and commodities. As a result, our forecasts for the equity markets are biased toward limited earnings gains and PE expansion. As the VIX continues to move on inflation and Fed expectations, we think 2023 will maintain VIX in the 18-30 range until its clear the inflation battle has relented.
Policy, trade and geopolitical risks are the three primary risks we are focusing on in 2023. Should the expected slowdown spiral out of control in a tight monetary policy environment, it is possible policymakers do not react quickly enough to stem what could become systemic malaise. Regarding the de-globalization we have seen in trade, there is a risk that supply chain impacts will not improve quickly enough to curb inflation. The various geopolitical stress points have the potential of increasing volatility and dousing underlying economic and market hopes. Since the Easterly Hedged Equity Fund (JDIEX) directly hedges against equity downside and can benefit from increases in volatility, it’s a solid diversifier in this type of environment. With interest rate policy likely to remain tight for the foreseeable future, investors looking to solely diversify with interest rate-based allocations could be disappointed, as they were in 2022.
Equity Volatility and Portfolio Positioning
As stated above, we anticipate volatility levels to remain elevated with potential spikes as inflation data and Federal Open Market Committee (FOMC) decisions approach. When volatility is elevated, our Fund’s options structure adjusts. For example, the Fund expands the traditional 2-7% downside, (buying the 2% out-of-the money “OTM” put and selling the 7% OTM put) to a wider 5% OTM to 12% OTM. The tranches of option positions also shorten in duration from 4–6-weeks to 2–3-weeks. The call options we sell, to help finance the defensive put spreads, will also move from the typical 2% OTM to potentially 5-10% OTM, giving the Fund greater potential for upside participation. These adjustments are not discretionary, but result from the changes in option premiums that are a by-product of heightened volatility.
Benefits of a Hedged Equity Product like JDIEX
The answer to this question depends on the nature of the volatility. Interestingly, our research has found that volatility can remain elevated, even in a positive equity market. We could experience this type of market in 2023 with the VIX futures curve still showing elevated levels of 26+ into late 2023, well after the Fed is due to have stopped hiking rates. The reason to utilize a strategy such as JDIEX in rising markets, is that it can defend against unforeseen declines while participating in market gains. Should volatility remain elevated, and the market range bound, the Fund will benefit from the ability to sell out-of-the money short term calls that expire worthless. That premium collection, with a lowered risk of not participating in the upside (because the market didn’t rise above call levels) gives the Fund an additional way to earn return that pure equity products don’t possess. If the markets, however, rise significantly and volatility were to drop, that advantage is diminished (like 2017) and we would expect to participate at a lower level in the 30% range.
The Breakdown of Stock and Bond Correlation
Much has been written the past few years about the death of the 60/40 portfolio and how the correlation of bonds and stocks have become positive over the past year. We would point out that the increased use of credit and spread products to overcome lower yields of the last decade also increased the correlation of portfolios to equities. While interest rates have risen, returning some defensive value to bonds, the elevated use of credit products still gives overall portfolios a greater risk of an equity correlation spike than generally understood. Because JDIEX uses the S&P 500 as its base and utilizes an S&P options overlay, the return pattern has no basis or correlation risk in its performance signature.
While it is possible that the correlation of bonds and stocks, on a trailing basis, return to more expected levels of low to negative correlation, it is important to note that correlation is rarely stable for any meaningful amount of time. The work we have done show that correlations can have frequent and significant moves when investors need them to be stable. The correlation characteristics of JDIEX are systematically managed to be stable and reduce correlation to the S&P when declines move through the 1 standard deviation range. The other important factor to consider is that the put spread collar structure the Fund uses manages the hedge process to an even or positive carry status. So, the cost of hedging is solely experienced as reduced participation, not a decrease in NAV.
JDIEX Positioning in Portfolios for 2023
Elevated volatility and potential recession remain a concern for equities. As a result, we believe it’s prudent to consider allocations to JDIEX as part of a core equity allocation. We see the risk of recession and credit spread widening as warranting reduced exposure to lower quality credit. For investors with a longer time horizon, JDIEX can serve as a good diversifier during periods of volatility to reduce the greater risk these investors can take with their equity allocation. The Fund tends to have higher returns over time than fixed income investments thus investors can benefit from allocations to JDIEX. This has been shown with both improved returns and risk adjusted statistics versus traditional allocations.
|Morningstar Options Trading Category||5.09%||-9.61%||2.62%||3.06%||2.74%|
|S&P 500 TR||7.56%||-18.11%||7.66%||9.43%||10.51%|
Performance data quoted above is historical. Past performance does not guarantee future results and current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that shares when redeemed may be worth more or less than their original cost. Investors cannot directly invest in an index, and unmanaged index returns do not reflect any fees, expense, or sales charges. For performance information current to the most recent month-end, please call 888-814-8180.
Source: Morningstar Direct.
Total return for all periods less than one year is an aggregate number (not annualized) and is based on the change in net asset value plus the reinvestment of all income dividends and capital gains distributions.
The Fund’s management has contractually waived a portion of its management fees until March 19, 2023 for I, A, C and R6 Shares. The performance shown reflects the waivers without which the performance would have been lower. Total annual operating expenses before the expense reduction/reimbursement are 1.92%, 2.12%, 2.76% and 1.92% respectively; total annual operating expenses after the expense reduction/reimbursement are 1.38%, 1.63%, 2.38% and 1.12% respectively. 5.75% is the maximum sales charge on purchases of A shares.
The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least March 19, 2023 for I, A, C and R6 Shares, to ensure that net annual operating expenses of the fund will not exceed 1.25%, 1.50%, 2.25% and 0.99%, respectively, subject to possible recoupment from the Fund in future years.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyAM.com.
Risks & Disclosures
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and Orange Investment Advisors, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
The Fund will borrow money for investment purposes. Leveraging investments, by purchasing securities with borrowed money, is a speculative technique that increases investment risk while increasing investment opportunity. Derivatives may be volatile, and some derivatives have the potential for loss that is greater than the Fund’s initial investment. If the Fund sells a put option, there is risk that the Fund may be required to buy the underlying investment at a disadvantageous price. If the Fund purchases a put option or call option, there is risk that the price of the underlying investment will move in a direction that causes the option to expire worthless. The Fund’s ability to achieve its investment objective may be affected by the risk’s attendant to any investment in equity securities.
Shares of ETFs have many of the same risks as direct investments in common stocks or bonds. In addition, their market value is expected to rise and fall as the value of the underlying index or bonds rise and fall. It is possible that the hedging strategy could result in losses and/or expenses that are greater than if the Fund did not include the hedging strategy. The use of leverage by the Fund or an Underlying Fund, such as borrowing money to purchase securities or the use of derivatives, will indirectly cause the Fund to incur additional expenses and magnify the Fund’s gains or losses. Because a large percentage of the Fund’s assets may be invested in a limited number of issuers, a change in the value of one or a few issuers’ securities will affect the value of the Fund more than would occur in a diversified fund.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.