Insight post

Apr. 14, 2018

The Importance of Consistency of Returns

The Importance of Consistency of Returns

Part 3: Math Matters Series

Consistency of returns is an important driver of overall investment results, just like in sports and other areas of our lives.

In fact, investors and advisors could learn a lot from the intentional consistency sought after by top sports performers.

Consistency Is King, Both in Sports and Investing

On July 24, 2016, the greatest ballplayer I’ve ever seen was inducted in the National Baseball Hall of Fame with a record-setting 99.3% of the vote. Reflecting on his career, Ken Griffey, Jr. recently said:

On the Mariners, we had this philosophy in the clubhouse that we referred to as Baseball Gods. Maybe it was more of a superstition than a philosophy. When someone referred to Baseball Gods, we were acknowledging that this game will make you feel human really fast: Never get too high on yourself and never get too low. It was a reminder that you’re never as bad as they say you are and never as good as you think you are.”

What Griffey said about baseball can also be said about the markets: they always have a way of humbling you. It’s important to keep your head on straight when markets are either soaring or crashing.

Unfortunately, that’s easier said than done given the wild ride the markets have been on over the last decade or two. The graph below shows a breakout of annualized returns for every three-year period between July 1,1997 to December 31, 2017.

Distribution of Three-Year Returns S&P 500 - Importance of Consistency - Swan Insights

Source: Zephyr StyleADVISOR, Swan Global Investments. S&P 500 returns from July 1, 1997 to December 31, 2017.

 

 

Return Distribution: A Test of Consistency

A plain English description of this distribution might be “feast or famine.” The more formal, statistical description is that this is a bi-modal distribution.

Usually a distribution will be clustered near the mean, or average result, and then gently slope off in both directions.

However, this distribution has two or maybe even three peaks (tri-modal). A large number of occurrences cluster in 10%-to-18% range, which represents a very healthy return.

In addition, there are also many occurrences where the annualized three-year returns were in the -8% to -14% range. Even more interesting, while the average three-year annualized return for the S&P 500 is 5.65%, there are very few times since July 1997 that the S&P 500 was close to its average—it was typically either way above or way below.

Distribution of Ten-Year Returns S&P 500 - Importance of Consistency - Swan Insights

Source: Zephyr StyleADVISOR, Swan Global Investments. S&P 500 returns from July 1, 1997 to December 31, 2017.



A similar, bi-modal distribution appears when looking at long-term, ten-year annualized returns. The largest bucket representing 39.4% of the outcomes is the 6% to 8% range; a perfectly acceptable result for most investors.

Worryingly though, the second most frequent range of ten-year returns is actually negative, ranging from -2% to 0%. Combined with the -4% to -2% bucket, 22.0% of the observations in this range were “lost decades.”

Seeking Narrow Distribution or Return Consistency

The Defined Risk Strategy (DRS) was designed to mitigate the impact of these outlier events and possibly provide a smoother, more reliable, more consistent outcome. By actively hedging against bear markets, the DRS has a much smaller “left tail” of bad outcomes. Over its 20-year history, the DRS Select Composite has weathered the two largest bear markets since World War II: the dot-com bust of 2000–2002 and the financial crisis of 2007-09. Below we see the distribution of annualized three-year returns of the DRS Select Composite compared to the S&P 500.

Distribution of Three -Year Returns S&P 500 & DRS - Importance of Consistency - Swan Insights

Source: Zephyr StyleADVISOR, Swan Global Investments. The S&P 500 Index is an unmanaged index and cannot be invested into directly. Past performance is no guarantee of future results. DRS results are from the Swan DRS Select Composite, net of all fees, from July 1, 1997 to December 31, 2017.

By hedging with long-term put options, the DRS Select Composite has historically minimized the impact of those bear markets. The distribution of DRS returns is what one hopes to see—the majority of returns are clustered near the average of the distribution.

The long-term returns of the DRS Select Composite are much more predictable. There isn’t a second peak to the distribution out in negative territory like there is for the S&P 500.

Of course, by maintaining the hedge at all times, the DRS will lag in up markets. There will be fewer observations in the high-teens or over-20% range. However, that is a trade-off the DRS Select Composite has willingly accepted. It has always been Swan’s philosophy that avoiding losses is more important than capturing all of the market’s gains.

The logic and justification for this are spelled out in our white paper “Math Matters” by Swan’s Director of Research, Micah Wakefield.

Distribution of Five-Year Returns S&P 500 & DRS- Importance of Consistency - Swan Insights

Source: Zephyr StyleADVISOR, Swan Global Investments. The S&P 500 Index is an unmanaged index and cannot be invested into directly. Past performance is no guarantee of future results. DRS results are from the Swan DRS Select Composite, net of all fees, from July 1, 1997 to December 31, 2017.

Compared to the S&P 500, the DRS Select Composite’s annualized five-year returns look very appealing. Almost two-thirds of the 187 observations occurred in the 6% to 10% range. The two most common buckets for the S&P 500 were the -2% to 0% and 0% to 2% ranges.

Distribution of Ten-Year Returns S&P 500 & DRS - Importance of Consistency - Swan Insights

Source: Zephyr StyleADVISOR, Swan Global Investments. The S&P 500 Index is an unmanaged index and cannot be invested into directly. Past performance is no guarantee of future results. DRS results are from the Swan DRS Select Composite, net of all fees, from July 1, 1997 to December 31, 2017.

With a track record of over 20 years, the sample size affords a healthy number of decade-long returns to analyze—127 observations in all. The long-term results of the DRS Select Composite show a remarkable degree of consistency. Again, the value of hedging against bear market losses is easily illustrated in this chart.

Return Consistency Addresses Investment Timing Risk

Another secondary, finer point of these charts has to do with timing.

At Swan, we are often asked, “When is the best time to buy the DRS?” If an investor’s previous market experience has been in something like the S&P 500, it is a perfectly rational question to ask.

As we have seen, over the last 20 years one could have experienced radically different results, depending upon the time frame in question. However, the DRS Select Composite almost renders this question moot as the range of outcomes has been very tight, as seen in the next table:

Consistency Returns over Market Cycles - Importance of Consistency - Swan Insights

Source: Zephyr StyleADVISOR, Swan Global Investments. The S&P 500 Index is an unmanaged index and cannot be invested into directly. Past performance is no guarantee of future results. DRS results are from the Swan DRS Select Composite, net of all fees, from July 1, 1997 to December 31, 2017.

As Mr. Griffey said, it’s important not to get too high or too low.

(Original post: October 27, 2016;  Updated: April 24, 2018)

About the Author:

Marc Odo, CFA®, 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.

Important Disclosures:

Cover image source: Yahoo!

 

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. 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. The Swan Defined Risk Strategy Select Composite demonstrates the performance of non-qualified assets managed by Swan Global Investments, LLC since inception. It includes discretionary individual accounts whose account holders seek the upside potential of owning stock, and the desire to eliminate most of the risk associated with owning stock. The Composite relies on LEAPS and other options to manage this risk. Individual accounts own S&P 500 exchange traded funds and LEAPS associated with the exchange traded funds as well as multiple other option spreads that represent other indices that are widely traded. The Defined Risk Strategy was designed to protect investors from substantial market declines, provide income in flat or choppy markets, and to benefit from market appreciation. Stock and options are the primary components of the strategy. Swan claims compliance with the Global Investment Performance Standards (GIPS®). All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. 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.

 

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 and comparing results among the Swan products and composites may be of limited use. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any benchmark. Therefore, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of 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. This analysis is not a guarantee or indication of future performance. 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. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970.382.8901 or visit www.swanglobalinvestments.com. 177-SGI-042618