The DRS does not want a linear relationship to the market. The DRS seeks to participate in markets when they are rising, but actively hedges against downward moves.
The goal of the DRS is illustrated by a target return band. The target return band is one of the key concepts or tools we use at Swan.
- The diagonal red line is the profit-loss diagram for the S&P 500.
- The curved gold line represents the redefined return profile of the DRS’s hedged equity position: 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 is still upward sloping. In down markets, the hedged equity positions flatten out as the S&P 500 continues to drop.
- The grey-blue area around the gold curve is the anticipated 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. In 20 of 21 years, they have been.
For an in-depth discussion of the target return band please refer to the blog post, “The Target Return Band.”
Vanguard, American and DFA were chosen as representatives for the different investment approaches due to their popularity with investors and their long track records. However, based upon the results seen in the first section, I could have run similar regression analysis on just about any of the 1,451 mutual funds in the domestic equity space, and the vast majority of funds would have had scatterplots that looked very similar to American or DFA. This is why at the outset of this blog series, we made the claim that the decision between active and passive management is not the debate we should be having. The real risk to an investor, the risk we should be focused upon, is systematic risk.