A successful money manager might be in business for decades. Alternatively, successful insurance companies have been around for centuries. Ultimately, an insurance company bears the risk of policy claims, and its balance sheet must be strong enough to withstand those claims when they come in. A successful insurance company must invest their assets well, be very cognizant of the probabilities of unfavorable outcomes, and generate sufficient revenue in order to stay in business. Suffice to say, a hit of 30% or more to its balance sheet could be catastrophic.
Many of those insurance principles are seen in the DRS:
- Exposure to the equity markets is maintained via low-cost ETFs, without any attempt to outsmart the market via stock selection or market timing.
- Downside risk is mitigated via the holdings in long-term put options.
- Revenue is generated from the premium collection trades.
These three primary building blocks are complementary and seek to provide a source of returns in just about any market environment. After all, the market can do one of three things: it can go up, it can go down, or it can stay flat.
- The first component, equity, does well when markets go up.
- In the second component, the hedge gains value if the markets go down.
- With the third component, if the markets stay flat and range bound in a short time horizon, the premium collection trades tend to do well.
It can be said with a high degree of certainty that in no environment will all three components positively contribute to performance. However, in any given environment, at least one, if not two, of the three components may contribute positively to the DRS.
This, of course, is by design and is a manifestation of a truly diversified strategy.
To dampen overall portfolio volatility, the individual components need to have a low or negative correlation. Historically speaking, the hedge component has been negatively correlated to both the equity position and the income trades, and the income trades have had a low correlation to the equity stake.