TICKERS: Institutional Class: HIOIX, Class A: HROAX
PORTFOLIO MANAGERS: Allen Gillespie, CFA®, David Lewis, CFA®, John Mills
Dear Fellow Shareholders,
In the second quarter, the Institutional Class of the Fund gained 18.99%. The fund’s factsheet contains additional information, including the performance of other shares classes.
The 60/40 Balanced Portfolio
In times past, moderately conservative investors might choose to allocate their funds 60%-70% to the equity side of their portfolio and 30-40% to the fixed income side of the portfolio. The 60/40 portfolio, as it is called, has largely stood the test of time because over the last 100 years, in the United States, stocks have been up 70% of the time on an annual basis, as measured by the Dow Jones Index.
Today’s market presents three challenges to this traditional investing approach. First, regular technology driven disruption can quickly upset the business models of even the most established companies. Second, many high-quality businesses choose not to pay dividends. Third, interest rates are at historically low levels, so bonds provide limited cashflow or stability.
A 60/40 portfolio today produces a combined yield of approximately 2%. Furthermore, of the 10 largest stocks in the US stock market, only five pay a dividend. In addition to low yields and dismal dividends, the 60/40 portfolio’s bonds would contain excessive interest rate and credit risk. In fact, during the recent March decline, corporate bonds fell almost as much as equity markets.
Investment Philosophy – In Action
The table below illustrates how the FinTrust Income and Opportunity Fund modernizes the 60/40 portfolio.
The fund’s strategy seeks to first invest in the highest quality businesses, regardless as to whether or not the company pays a dividend. The Fund’s investment thesis is that “high quality businesses are best identified through an analysis of a company’s intellectual property (“IP”) portfolio.” Patents, trademarks, and copywrite laws help companies create legal moats which defend against competition and protect profits.
Next, the fund utilizes the options market to create an income stream. One of the ways the fund does this is by selling off some upside potential of the stock to more aggressive, or some would say greedy, investors. We accomplish this through the selling of covered calls.
Third, in many cases, the option premium income stream created by the fund has less interest rate and credit risk than a traditional 60/40 portfolio. The example below illustrates the differences in the 10-year compounded annual growth rate (“CAGR”) between 2 traditional dividend paying stocks and 1 newer technology company. In addition to growth rates, there is a large difference in corporate balance risk and leverage between the three types of companies. A portfolio comprised of companies with cleaner balance sheets should be more resilient to both interest rate increases and credit stresses over time.
Understanding the Payoff
In the example provided above, taken from recent market pricing, the fund might sell-off the gains of Company A above. This would mean a 16% return, in return for a 5% call option premium. In this type of position, the fund would have 21% upside potential and 5% downside protection.
The Economic & Investing Climate
As highlighted in the year-end letter, equity valuations are in the very upper percentiles of historical averages. Today’s high equity valuations are due in large part to historically low interest rates. In fact, according to Bloomberg, there were recently over $13.9 trillion of negative yielding bonds globally.
This year’s first quarter brought the overvaluation reality painfully home for investors, as the S&P 500 dropped 19.60%. At the worst point of the decline, stocks were down over 30% peak to trough, in line with our estimates of the market’s overvaluation. Fortunately for investors, the Federal Reserve and Federal Government, quickly responded to the deteriorating conditions and passed a tremendous amount of stimulus. The Federal Reserve lowered short-term interest rates to zero, and the Federal Reserve agreed to finance the Treasury’s purchase of corporate bonds. Meanwhile, the Federal Government passed nearly $3 Trillion in stimulus measures.
The stimulus has created a strong bounce in equity markets, and it improved forward looking economic indicators like the yield curve’s slope. The stimulus has also lowered corporate interest rates, though corporate borrowing rates still reflect recessionary conditions.
Corporate earnings are now down on a year-over-year basis, but it is important to note that equity market returns are historically positive over the course of a recession.
In summary, things are improving from severe recessionary levels, but today’s valuations and recessionary conditions are likely to create economic headwinds. The fund, however, owns high quality businesses with exciting growth prospects that are not as economically sensitive. In addition, the options market will continue to provide opportunities to balance the risk return trade-off and produce an acceptable cashflow during these challenging times.
Thank you for investing and joining us as fellow shareholders in the FinTrust Income and Opportunity Fund. We continue to work hard to justify your confidence and trust in our stewardship of your hard-earned savings. We remain dedicated to providing you with the information we would like to have if our roles were reversed. Please do not hesitate to contact us directly at (864) 288-2849 should you have any questions.
Shape the future,
Allen R. Gillespie, CFA
Managing Partner of Investments