Fund Overview
The Market Neutral Income Fund employs two different strategies that we believe complement the fund's investment objective. To best understand how the fund performed, we have addressed the environment for both strategies below.
Covered Call Writing Strategy
The 12.59% return in the S&P 500 Index was supportive to the covered call strategy in the first quarter, as the value of our equity basket increased up to the strike prices of the calls written against the basket, even as the equity basket slightly trailed the S&P 500 return.
Volatility continued to decline. The CBOE Volatility Index (VIX) ended at 15.36 from 23.40 at the beginning of the quarter. The long-term average of the VIX is near 20. At the same time, we saw disparity between the implied volatility priced into puts and calls. Lower volatility reduced the amount of premium that can be written on calls, but also reduced the cost of put protection.
The two-year Treasury was at 0.33% at the end of the first quarter while the 10-year Treasury was at 2.20%. The resulting 187 basis point spread is a 15 basis point increase from the end of the fourth quarter. The widening of spreads with the Treasury hedge portion of the covered call strategy resulted in a slight detraction to performance. It should be noted, however, that the Treasury hedge, as expected, performed with negative correlation to the S&P 500.
Convertible Arbitrage
The strong performance of the convertibles’ underlying stocks contributed positively to the convertible arbitrage strategy returns.
Volatility is important to convertible arbitrage, since an increase in volatility supports the embedded option value contained in the convertible and provides for opportunities for trading profits. The decline in volatility during the first quarter was negative for performance in this regard.
The near-zero federal funds rate (0.10%) at the end of the first quarter continued to provide some headwind to the convertible arbitrage strategy. The low interest rate environment has meant that the fund has not received short interest credit from the proceeds of the short sale of common stock in the portfolio. Additionally, with interest rates at historic lows, coupon yields on convertibles and other interest-bearing securities were also low. Low interest rates have also negatively impacted new convertible issuance, although we did see several new issues in March that we were able to use within the fund.