Over the past few months, the S&P 500 has lost about 7% off its all time high in May. The week of August 17 to 21 the S&P 500 lost 5.7%, while the VIX rose 118%. Known as the “fear index”, the VIX’s one-week move was the largest since record keeping of the VIX began in 1990. The move over the last three market days of 103% was the second largest ever for the VIX, behind only the debt downgrade of August 2011 (105%). The VIX spiked over 46% on Friday alone, making it the fifth largest one-day move ever in the VIX. The primary factors driving this market drop and tremendous spike in volatility include:
- weak economic data outside the U.S.
- uncertainty about the timing of future rate hikes from the Federal Reserve
- continued plunging of oil prices (lowest level since March of 2009)
- rising anxiety over slowing growth in China, which has also seen a substantial market correction over the past few months.
During this period of time, the Swan Defined Risk Strategy has performed as we would expect in this type of market environment. The downside capture ratio during the past week was higher than what some newer investors might expect as a direct result of our income component’s unrealized losses caused by the decline in the market and spike in volatility. This short-term downside capture ratio should not be interpreted by investors as an indication on the effectiveness of the hedge; in fact, the hedge is fully in place and has actually performed better than expected during this time. Each portfolio is hedged at 100% of the notional value and is always in place.
More than 50% of the strategy’s decline over the past week is due to the income component, as should be expected from such a large VIX spike. At the same time, the better-than-expected performance of the hedge is due to its increased value attributed to the increase in volatility. We will always expect a temporary higher-than-expected downside capture ratio to be associated with a significant and rapid spike in volatility and the ultra short-term downside capture ratio will temporarily mask the true effectiveness of the hedge. Both components are still a necessary part and vital contributors to the overall strength of the DRS. Any unrealized or realized losses on our short-term options positions are only temporary and the sustained increase in volatility will allow our strategy to collect higher premiums from selling short-term options in the near future. The higher premiums collected should increase realized profits, helping offset the cost of the long-term hedge. As always, we will follow our approach to stay fully invested and fully hedged during all market environments.
If this is the beginning of what many consider a long overdue bear market, we believe there is no better strategy than the DRS across a full market cycle, both bull and bear.
If the current downtrend continues, our separation relative to the S&P 500 will likely accelerate as our hedge becomes more valuable. Based on past corrections, we would expect the hedged equity of our strategy to capture approximately 50% of the first 10% of a market drawdown, 25% of the next 10%, with minimal losses if the S&P 500 drawdown exceeds 20% over a period of time. Combined with our income trades there have been times in the past that the strategy has captured slightly more downside than the S&P in the short-term. This is not the case here due to the close proximity of the put to the market level.
It is important to remember that Swan’s goal is to prevent large declines. Smaller short-term pain and drawdowns will occur with sudden spikes in volatility. This approach has proven itself numerous times over since 1997 through all types of market environments (Long Term Capital Management, 9/11, Tech and Financial bubbles, Flash Crash, downgrade of U.S. Debt) and we believe will continue to do so in future events. Studies have conclusively shown that shortsighted and ill-advised attempts to time the market by getting in and out, especially during periods of extreme volatility, have harmed investors. DALBAR releases each year a study called “Quantitative Analysis of Investor Behavior” which points to the inherent dangers of investors trying to time the market, as seen here in this year’s study:
- Returns are for the period ending December 31, 2014. Average equity investor, average bond investor and average asset allocation investor performance results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for each period.
The information above from the DALBAR study shows how poorly the average investor has performed compared to the market due primarily to fear and resulting attempts to time the market by getting in and out of their investments. Investors likely become frightened in down markets, finally cannot take it any longer, and sell at a low and then take too long to get back in and end up buying at a high. While the S&P 500 posted a healthy annualized return of 11.06% over 30 years, the average mutual fund investor gained a paltry 3.79% over the same period. A $100,000 investment compounded at 3.79% per year grows to $305,257 over 30 years, whereas an 11.06% growth rate increases that value to $2,326,645 — a staggering difference in wealth.
Swan’s unique Defined Risk Strategy (DRS) provides investors an alternative or complement to traditional asset allocation strategies. The DRS is designed to seek absolute returns with separate but complementary components for up, flat, and down markets. Most importantly, the DRS is designed to seek to minimize unsystematic and systematic risk.