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Okay, thanksSwan Global Investments is a pioneer in hedged equity investing. Founded in 1997, Swan’s motto has been “Always Invested, Always Hedged” for over a quarter century. There were very few money managers promoting hedged equity in the late 1990’s.
Therefore, it has been gratifying and validating to witness the explosion of interest in hedged equity over the last five years. According to Morningstar, as of June 30th, 2024 there is almost $100 billion invested across 438 Options Trading mutual funds and ETFs.
Source: Morningstar Direct, Swan Global Investments
What is interesting about the growth of hedged equity is that most of the assets are held in passively managed structures. Many hedged equity strategies are “set it and forget it”, establishing their hedge points once a quarter or once a year. They do not consider market movements or try to maximize the value of their hedge.
In contrast, Swan has always actively managed its hedged equity strategies. Our time-tested process seeks to “sell high and buy low” by re-balancing the hedge and equity portions of its portfolios at opportune times. Swan believes actively managing hedged equity confers the following advantages:
Before discussing the advantages of an actively managed hedging strategy, it is important to understand how most passively managed hedged equity funds are structured.
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Most of the buffered outcome ETFs as well as the largest hedged equity mutual funds are all employing variations of the same trade, known as a put spread collar. This trade has the following features:
The put spread collar has a payout structure as illustrated below.
Source: Swan Global Investments
Once this trade is established, nothing else happens. It is a passively managed trade. Other than managing cash flows, the portfolio manager doesn’t need to do anything until the options expire a quarter or a year later, at which point the trades are reestablished.
The advantage of the put spread collar in a down market is that if the market losses are modest, the investor will participate in little or perhaps none of the downside. The advantage of this trade in an up market is that if the market gains are modest, the investor will participate in most of the upside.
However, the disadvantages to the put spread collar exist when the market is up or down by more than a modest amount, i.e. a strong trending market.
The other concern facing put spread collars is simply the sheer number of strategies are essentially all doing a variation of the same trade. The graphs below illustrate that over 80% of the funds by both product count and AUM are utilizing a put spread collar or a traditional collar.
Source: Morningstar Direct, Swan Global Investments
The put spread collar trade is getting crowded. In contrast to this passive approach, Swan actively manages its hedged equity strategies. Swan believes active management offers several advantages.
* A close relative to the put spread collar trade is the collar trade. The collar doesn’t have the open-ended tail risk in a market downturn, but the caps tend to be much lesser than in a put spread collar. Collars are common, but not as widespread as put spread collars.
One fundamental truth about options is that every option eventually expires. If the option is not “in the money” at the time of expiration, it becomes worthless. The closer the option gets to its expiration date, the more it loses value. This is known as “time decay.”
One key to understanding option pricing is that time decay does not happen in a straight line. Early in an option’s life cycle the time decay isn’t as costly. It’s when the option gets closer and closer to expiring does time decay really start to negatively impact the value of the option.
For this reason, Swan typically uses put options with a much longer lifespan, typically expiring in two years.
This annual rolling of the hedge is illustrated below.
Source: Swan Global Investments
This contrasts with the buffered outcome ETFs. Buffer ETFs explicitly state that to realize the stated caps or buffers, one must hold the ETF for the full one-year period. Options are held to expiration, by design.
One of the cardinal rules for successful investing is “buy low, sell high.” Swan’s active management seeks to exploit periods of market weakness by “cashing in” the value of its put options during market sell-offs. The image below illustrates this process.
Source: Swan Global Investments
Swan’s hedged equity strategies typically start the year with an equity-to-put option ratio of roughly 90:10. However, if the markets sell off significantly that ratio will change. The equity portion will track the market downwards while the put options should accelerate in value the greater the market sell-off. Rather than simply wait around for the market to recover, Swan’s portfolio managers will typically:
We can see this active management of the re-hedge during the rising interest rate bear market of 2022:
Finally, at the end of 2022 Swan reset all its put options to avoid the steeper time decay as they approach expiration and to enter 2023 with the hedged at near-market levels.
This contrasts with the passive put-spread collar approach. In a year where the S&P 500 was down 18%, a defined outcome fund with buffers of 10% or 12% would have been exposed to losses beyond that point.
Source: Morningstar Direct
In addition, a buffered fund has no mechanism to “buy low” while the market is at its low point. The investor can either sell out of the ETF or wait for the options to expire and the trade to reset.
The flip side of the previous situation is active management in an up market.
If the market moves up significantly, Swan’s portfolio managers can and will replace the existing put options with new put options featuring a higher strike price.
By doing so, the fund is actively engaging in some profit-taking in a bull market.
Source: Swan Global Investments
Moreover, it is ratcheting up the hedge level, so if the market reverses the new put options are in a better position to offset the downside risk. The graph above illustrates the active management during upwards markets.
Swan has set higher re-hedge points three times since the start of 2023. Two were intra-year re-hedges, where a portion of the put options were rolled up to higher strike prices. The other re-hedge occurred in late 2023 when all the put options were exchanged for new put options with a two-year expiration cycle to avoid the steep drop-off in value described previously.
Again, this active management stands in contrast to the passive approach used by buffered outcome funds. If a buffer fund had a one-year upside cap of, say, 12% in 2023, it would have left a lot of money on the table when the S&P 500 was up 26.3%. Unless the investor sells the ETF, they must wait for the existing options to expire before receiving a new cap.
To be clear, Swan Global Investments is not opposed to put spread collars or buffered outcome funds. We are quite pleased to see hedged equity play a larger role in investor allocations. There is no one single strategy that performs best in all environments and there will be situations when buffered ETFs perform well.
However, Swan believes active management can add value within the hedged equity space. By managing the cost of hedging via rolling out of the put options before they expire and by “selling high and buying low” Swan seeks to provide a better outcome for its investors.
Marc Odo, CFA®, FRM®, 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. His responsibilities also include producing most of Swan’s thought leadership content. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.
Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.
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 offers and manages the DRS for investors including individuals, institutions and other investment advisor firms.
All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser 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 www.swanglobalinvestments.com. 167-SGI-091124
