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Okay, thanksWhen Randy Swan first developed the Defined Risk Strategy (DRS) in 1997, it was designed to be a total portfolio solution. Randy started investing at an early age and tried many of the strategies available: buy-and-hold, market-timing, stock-picking, traditional diversification, etc. Those strategies did not prevent him from feeling the pain of the 1987 “Black Monday” crash or the 1990-1991 recession. It wasn’t until he started working with insurance companies while at KPMG that he struck upon the ideas that would one day become the DRS.
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:
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.
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.
Over the course of its 20-year history, the DRS has seen many different market environments and events, including:
Throughout a two-decade period that encompassed many peaks and valleys, the 100% Swan DRS Select Composite outperformed both the S&P 500 and a 60% equity/40% bond portfolio. Even though the current bull market is in its eighth year and is the second-longest bull market in U.S. history, the downside protection the DRS generated through the bear markets of 2000-02 and 2007-09 have compensated for its underperformance relative to the S&P 500 during the last several years.
Source: Swan Global Investments and Morningstar; the Barclays U.S. Aggregate Bond Index and the S&P 500 Index are unmanaged indices, and cannot be invested into directly. Past performance is no guarantee of future results. Swan DRS results are from the Select Composite, net of fees, as of 6/30/2018. Structures mentioned may not be available within your Broker/Dealer.
Only the most optimistic and foolish investors would argue that bear markets have been banished forever.
When the next bear market does arrive, the DRS will be prepared.
All that said, we realize that most investors are unable or unwilling to invest 100% of their money with the DRS. The DRS can still perform a constructive role within a portfolio either as a core equity solution, as a distribution vehicle, or as a capital preservation vehicle.
(Updated 8/6/2018, Orginal post 5/26/2017)
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.