At Swan Global Investments, we are frequently asked “In which category do you belong?” or “Who are your competitors?” We believe that the Defined Risk Strategy is a rather unique solution, and no one is currently doing what we are doing. The DRS doesn’t fit nicely into a predefined box.
That said, it is inevitable that the Defined Risk Strategy gets compared against other managed products. This post will be the first in a series where we compare and contrast the DRS against other types of investment strategies. Because we are most frequently compared to tactical asset allocation or market-timing strategies, this is where we will start.
The one and only thing that the DRS has in common with tactical asset allocators is an aversion to down markets. Passive strategies or stock-pickers who hew closely to a benchmark will track their benchmarks on both the upside and the downside. If the market has a major sell-off, stock pickers typically offer little downside protection, and passive strategies offer none. Both the Defined Risk Strategy and most tactical asset allocators attempt to actively minimize exposure to down markets.
However, the manner in which tactical asset allocators (TAA) and the DRS attempts to accomplish this goal couldn’t be more different.
The typical tactical asset allocator’s value proposition is based upon market timing. A TAA strategy will typically make significant, top-down changes to their strategy’s asset allocation based upon changing forecasts on the marketplace or some sort of indicator based on past historical occurrences.
A simplified description of a tactical asset allocator’s philosophy might be, “The best way to not lose money is to avoid the asset classes with the worst performance.” Moreover, the opportunity set of a tactical asset allocation strategy is usually very broad. Unlike a large-cap stock picker that can only choose from a field of 500 or 1,000 stocks, the opportunity set for a TAA strategy is much broader.
In theory, this is a good way to minimize losses. As the table above illustrates, there can be wide dispersions between the best and worst performing asset classes. With a wide-open mandate, a tactical asset allocator could have many more asset classes to choose from.
However, the whole trick to being a successful tactical asset allocator is being in the right place at the right time. It’s just as easy to be caught out on the wrong side of the tracks. If a TAA gets their market calls wrong, the potential for underperformance is every bit as great as the potential for outperformance. The investment landscape is littered with TAA strategies whose “Midas Touch” eventually deserted them, leaving them well behind the market. I like to sum up the experience of TAA strategies as “live by the sword, die by the sword.”
Different Approaches to Downside and Upside
At Swan Global Investments we believe it is very difficult if not impossible to always be one step ahead of the market, as required by a market-timing strategy. It’s inevitable that any given TAA strategy will have some of their market timing calls work out in their favor and some will go against them, but we do not believe market-timing to be a sustainable long-term strategy.
Swan’s investment motto is “Always invested, always hedged.” We do not profess to know when markets will go up or go down. We remain always invested with a buy-and-hold position in a given market, in order to capture as much of the upside as we can. However, we never know when steep sell-offs might occur, so we always maintain a hedge to protect our assets against bear markets. We always maintain this hedged equity approach. I like to say it doesn’t matter if the markets are down 50% like they were during the Financial Crisis or if the market is in an eighth year of a bull market- the Defined Risk Strategy is always doing the same thing.
DRS. Vs Tactical Track Records — Which is More Replicable and Reliable?
Because Swan follows a very systematic approach, we can estimate with a fair degree of accuracy where our returns might fall in any given year, something that market-timers cannot do. The chart below is one we use frequently at Swan.
The diagonal red line is the profit-loss diagram for the S&P 500.
The curved gold line represents the return profile of our hedged equity position, that is, our buy-and-hold position in the market combined with the protective elements of our hedge.
The gold line lags the S&P 500 in up markets but is still upward sloping. In down markets, the hedged equity position’s losses flatten out as the S&P 500 continues to drop.
The blue area around the gold curve is the anticipated impact of overlaying Swan’s short-term premium collection trades over the hedged equity position.
It is our expectation that future returns of the DRS will be within or above the blue shaded area. In 17 of 18 years, they have been.
Source: Swan Global Investments
TAA strategies, on the other hand, have a high degree of uncertainty associated with them. In the graph below, we see a universe comparison on a year-by-year basis showing the range of returns from best to worst performers. The data set used here is Morningstar’s Tactical Asset Allocation category. We can see that in any given year the range separating the best performers from the worst can be quite wide. The performance dispersions you see here are much larger than the plain vanilla asset classes.
Wide performance dispersions shouldn’t be a surprise, given the fact that the asset allocations are all over the map.
In this last graph, we see the range of asset allocations within the TAA category. TAA funds can take big bets, and they do. Across the category, we see exposure to U.S. equity range from 0% to 85%. Cash ranges from 0% to more than 60%. U.S. bonds can be as low as nothing or as much as 50% of a portfolio.
Finally, tactical asset allocation strategies tend to have higher turnover ratios and are thus less tax efficient. Their whole value proposition involves the active buying and selling of asset exposure in order to outperform the market. As turnover and tax efficiency are closely related, this is an additional concern for TAA strategies.
That said, it is really the value proposition of TAA strategies that Swan does not share. We believe it is too difficult to consistently time the market and that market-timing should not be the basis for a long-term strategy. When TAA bets go wrong, they can go very wrong.
By now the arguments for and against picking stocks and indexing are well documented. At Swan Global Investments, our take on the whole passive-versus-active debate is a bit different. It doesn’t matter. Active or passive: it doesn’t matter. Dive into this engaging paper to learn why, and more importantly discover what may be overlooked in the broader passive vs. active debate.
Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, 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.
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. 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. Accordingly, 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 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. 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 swan-stg.statik.press. 214-SGI-082916