Insight post

Sep. 13, 2016

DRS vs. Tactical Asset Allocation

Strategy Comparison Series

DRS vs. Tactical Asset Allocation

At Swan Global Investments, we are frequently asked “In which category do you belong?” or “Who are your competitors?” We believe that the Defined Risk Strategy is a rather unique solution, and no one is currently doing what we are doing. The DRS doesn’t fit nicely into a predefined box.

That said, it is inevitable that the Defined Risk Strategy gets compared against other managed products. This post will be the first in a series where we compare and contrast the DRS against other types of investment strategies. Because we are most frequently compared to tactical asset allocation or market-timing strategies, this is where we will start.

The one and only thing that the DRS has in common with tactical asset allocators is an aversion to down markets. Passive strategies or stock-pickers who hew closely to a benchmark will track their benchmarks on both the upside and the downside. If the market has a major sell-off, stock pickers typically offer little downside protection, and passive strategies offer none. Both the Defined Risk Strategy and most tactical asset allocators attempt to actively minimize exposure to down markets.

Zephyr Drawdown Comparison - DRS vs Tactical vs Index - Swan Insights

Source: Zephyr StyleADVISOR


However, the manner in which tactical asset allocators (TAA) and the DRS attempts to accomplish this goal couldn’t be more different.

The typical tactical asset allocator’s value proposition is based upon market timing. A TAA strategy will typically make significant, top-down changes to their strategy’s asset allocation based upon changing forecasts on the marketplace or some sort of indicator based on past historical occurrences.

A simplified description of a tactical asset allocator’s philosophy might be, “The best way to not lose money is to avoid the asset classes with the worst performance.” Moreover, the opportunity set of a tactical asset allocation strategy is usually very broad. Unlike a large-cap stock picker that can only choose from a field of 500 or 1,000 stocks, the opportunity set for a TAA strategy is much broader.

Periodic Table of Asset Class Performance - Swan Insights

In theory, this is a good way to minimize losses. As the table above illustrates, there can be wide dispersions between the best and worst performing asset classes. With a wide-open mandate, a tactical asset allocator could have many more asset classes to choose from.

However, the whole trick to being a successful tactical asset allocator is being in the right place at the right time. It’s just as easy to be caught out on the wrong side of the tracks. If a TAA gets their market calls wrong, the potential for underperformance is every bit as great as the potential for outperformance. The investment landscape is littered with TAA strategies whose “Midas Touch” eventually deserted them, leaving them well behind the market. I like to sum up the experience of TAA strategies as “live by the sword, die by the sword.”


Different Approaches to Downside and Upside

At Swan Global Investments we believe it is very difficult if not impossible to always be one step ahead of the market, as required by a market-timing strategy. It’s inevitable that any given TAA strategy will have some of their market timing calls work out in their favor and some will go against them, but we do not believe market-timing to be a sustainable long-term strategy.

Swan’s investment motto is “Always invested, always hedged.” We do not profess to know when markets will go up or go down. We remain always invested with a buy-and-hold position in a given market, in order to capture as much of the upside as we can. However, we never know when steep sell-offs might occur, so we always maintain a hedge to protect our assets against bear markets. We always maintain this hedged equity approach. I like to say it doesn’t matter if the markets are down 50% like they were during the Financial Crisis or if the market is in an eighth year of a bull market- the Defined Risk Strategy is always doing the same thing.


DRS. Vs Tactical Track Records  - Which is More Replicable and Reliable?

Because Swan follows a very systematic approach, we can estimate with a fair degree of accuracy where our returns might fall in any given year, something that market-timers cannot do. The chart below is one we use frequently at Swan.

  • The diagonal red line is the profit-loss diagram for the S&P 500.
  • The curved gold line represents the return profile of our hedged equity position, that is, our buy-and-hold position in the market combined with the protective elements of our hedge.
  • The gold line lags the S&P 500 in up markets but is still upward sloping. In down markets, the hedged equity position’s losses flatten out as the S&P 500 continues to drop.
  • The blue area around the gold curve is the anticipated impact of overlaying Swan’s short-term premium collection trades over the hedged equity position.

It is our expectation that future returns of the DRS will be within or above the blue shaded area. In 17 of 18 years, they have been.

Swan Targeted Return Band - Annaul Returns Defined Risk Strategy since Inception - Swan Insights


TAA strategies, on the other hand, have a high degree of uncertainty associated with them. In the graph below, we see a universe comparison on a year-by-year basis showing the range of returns from best to worst performers. The data set used here is Morningstar’s Tactical Asset Allocation category.  We can see that in any given year the range separating the best performers from the worst can be quite wide. The performance dispersions you see here are much larger than the plain vanilla asset classes.

Morningstar Peer Performance Chart - Tactical vs Russell 1000TR - Swan Insights

Wide performance dispersions shouldn’t be a surprise, given the fact that the asset allocations are all over the map.

In this last graph, we see the range of asset allocations within the TAA category. TAA funds can take big bets, and they do. Across the category, we see exposure to U.S. equity range from 0% to 85%. Cash ranges from 0% to more than 60%. U.S. bonds can be as low as nothing or as much as 50% of a portfolio.

Morningstar Peer Performance Chart - Tactical vs Open End Funds - Swan Insights

Finally, tactical asset allocation strategies tend to have higher turnover ratios and are thus less tax efficient. Their whole value proposition involves the active buying and selling of asset exposure in order to outperform the market. As turnover and tax efficiency are closely related, this is an additional concern for TAA strategies.

That said, it is really the value proposition of TAA strategies that Swan does not share. We believe it is too difficult to consistently time the market and that market-timing should not be the basis for a long-term strategy. When TAA bets go wrong, they can go very wrong.

That is why the Swan Defined Risk Strategy sticks to the motto:  “Always Invested, Always Hedged.”

About the author:

Marc OdoCFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.

Research from this Author
Important Disclosures:

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan Global Investments offers and manages the Defined Risk Strategy for investors including individuals, institutions and other investment advisor firms. All Swan products utilize the Swan DRS but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS  product  offerings  will  have  different  performance  results  and  comparing  results among the Swan products and composites may be of limited use. Indices are unmanaged and cannot be invested into directly.  Past performance is no guarantee of future results.  DRS results are from the Select Composite, net of fees, as of 12/31/2016. The charts and graphs contained herein should not serve as the sole determining factor for making investment decisions. Hypothetical performance analysis is not actual performance history. Actual results may materially vary and differ significantly from the suggested hypothetical analysis performance data. This analysis is not a guarantee or indication of future performance. Swan claims compliance with the Global Investment Performance Standards (GIPS®). Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes nonqualified discretionary accounts invested in since inception, July 1997 and are net of fees and expenses. All data used herein; including the statistical information, verification and performance reports are available upon request.

The benchmarks used for the DRS Select Composite are the S&P 500 Index, which consists of approximately 500 large cap stocks often used as a proxy for the overall U.S. equity market, and a 60/40 blended composite, weighted 60% in the aforementioned S&P 500 Index and 40% in the Barclays US Aggregate Bond Index. The 60/40 is rebalanced monthly. The Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.

The advisor’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the advisor invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. Further information is available upon request by contacting the company directly at 970.382.8901 or visit  214-SGI-082916