Although the Defined Risk Strategy (DRS) was originally designed to be a total portfolio solution, Swan Global Investments realizes it is unlikely that many people will place 100% of their money in the DRS.

One of the most frequently asked questions regarding the Defined Risk Strategy is, “Where does the DRS fit?” While it is true that the DRS can perform many different roles within a portfolio, we tend to position the DRS first and foremost as a core equity solution.

The flagship DRS solution, with its inception in July 1997, is based on large cap U.S. equity. Although the DRS is now offered upon other asset classes like small cap equity, foreign developed, and emerging markets, the flagship offering has always utilized U.S. large cap ETFs for its equity exposure. Typically, the DRS holds 85%-90% of its positions in ETFs.

One can make the case that the DRS is fundamentally a core equity position, with the hedge and income components overlaid on top of it. The DRs is distinctly always invested and always hedged.

If one were to compare the portfolio characteristics of the Swan Defined Risk Strategy Select Composite against the S&P 500 Index and the Morningstar category for Large Blend, the DRS is right in line with other core, large cap equity offerings.

Given the fact that typically 85% to 90% of the portfolio is held in S&P Select Sector ETFs, these numbers are completely logical. The strategy does, however, pursue more of an equal-weight sector approach to the market. The S&P 500 is a market capitalization-weighted index. The equal-weight sector approach leads to a bit of a tilt to both smaller names and value characteristics, which you see in the market cap and valuation tables, respectively. If one is a proponent of Fama-French and the belief that there is a systematic value premium and a small cap premium, the equal-weighted sector approach is a way to emphasize those factors. But there is little doubt that the portfolio characteristics of the DRS are large cap, core equity.

On the other hand, you will certainly see a difference of returns between the DRS and the S&P 500 index or the typical large blend mutual fund. If one were to look at traditional “tracking” metrics like correlation and R-squared, you will see much higher levels of dispersion from the S&P 500 than you would with a traditional large cap core fund.

This, of course, is by design. The whole intent of the DRS is to avoid those times when the market is down significantly. The driving idea behind the DRS is that those large bear markets are too painful to endure, so the DRS is engineered to have a different risk-return profile than a traditional long position.

The Target Return Band

One of the key charts we use at Swan to convey this message is the Target Return Band below:

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

It is our goal that returns of the DRS will be within or above the blue shaded area. Historically, in every year but one, they have been.

In our opinion, the DRS allows one to have their cake and eat it too. The investor has large cap, core equity exposure via our large holdings in the S&P Select Sector ETFs. However, the DRS redefines the risk-return profile of those holdings has been altered to manage and diminish the impact of bear markets.

It is this difference in return patterns and the use of options that drive some to classify the Defined Risk Strategy as an “alternative” strategy. The argument for treating the DRS as an alternative investment will be explored in an upcoming blog post.

Other roles we have explored in this series are:

• How much DRS is enough?
• A total portfolio solution
• A distribution vehicle
• Across multiple asset classes