Q: What is the history of the fund?
The Swan Defined Risk Fund was launched in 2012 based on a strategy I began in 1997. The strategy manages market risk directly by utilizing options. The fund is always invested, but it is also always hedged, all the time, using put options. Over an entire investment cycle, we can offer superior protection from market downturns while still delivering consistent returns.
We do not try to pick stocks or time the market. Instead, a hedge is created via long-term put options on exchange-traded funds (ETFs). The strategy is available across all the major equity asset classes. To control hedging costs and lock-in market gains we re-hedge annually. In addition, we generate income by selling short-term options
During bear markets we cash in on the large gains generated by the put option and re-invest in lower-priced shares. This allows us to buy low and sell high, and it produces the cash needed to do so. Thus, in an average bear market, hedging pays for itself and changes the distribution of outcomes. It actually becomes a profit center when bear markets are larger than average.
Obviously, the hedge is a drag on performance in other environments, but the costs of hedging are significantly lower than if were we hedging the portfolio on a 90-, 120-, or 180-day basis.
By maintaining a consistent approach to managing market risk, the fund performs well under multiple market conditions and delivers returns not available to its buy-and-hold, long-only peers.
Q: What core principles guide your investment philosophy?
We do not spend time, energy, or effort trying to pick winning stocks or time the market. We do not believe either can be successful in the long haul. We also think that Modern Portfolio Theory or asset allocation is limited in its ability to protect against market risk.
Our focus is on using low-cost, tax-efficient ETFs and ETF-like products covering all the major asset classes for market exposure. Though our flagship strategy is based on the S&P 500 Index, we also apply it to emerging markets, U.S. small caps, foreign developed markets, Treasuries, gold, and real estate.
We add value by mitigating market risk through the intelligent and cost-efficient use of options. If market risk cannot be diversified away, we believe it must be hedged away. By remaining always invested and always hedged, our stated objective is to outperform the underlying asset over an entire investment cycle.
For investors with short time horizons, we may not be the right fit. The fund was designed to replace a 60/40 portfolio, so in a year like 2016 where equities are up more than 10% and fixed income has obviously had a bad time, the strategy still makes sense from a macro view.
Q: What is your investment process?
We typically invest 85% to 90% of the portfolio in an asset class using ETFs. Currently, the strategy is offered in seven different assets.
The next step of the process is to purchase a put option, which hedges the downside exposure of the underlying assets. Using the S&P 500 as an example, we would buy a two-year put option to hedge out most of the market risk. Over a one-year time horizon, downside risk exposure would be expected to be capped around high single-digit losses.
We like using long-dated put options for several reasons. They are a cost-effective hedge given our strategic belief to be always invested and always hedged.
Long-dated put options also provide the time for us to re-hedge the portfolio. As options get closer to expiration, they decay at an increasingly quicker rate, losing a tremendous amount of value in their last six months. We stay ahead of this rapid decay by buying a two-year put option, holding it for one year until expiration, selling it after a year, then replacing it with another new two-year put option.
This gives us some flexibility around re-hedging; generally we have about a two-month window where we can re-hedge the portfolio. Through bull markets, we lock in higher gains by increasing the strike prices of the put. When going through bear markets, strike prices are lowered and we realize a profit from the put options.
Finally, by using long-dated options, we can transfer increases in volatility to the next options we buy. After expiration, an option has no volatility value left. During times of increased market volatility, we believe it is important to transfer that value.
Short-dated options are useful, too, and are the third step of our investment process. By selling shorter-term options against long positions, we effectively hedge our hedge, generating additional income opportunities over market cycles.
Q: Can you illustrate your investment process?
The way the strategy performed during 2008’s financial crisis illustrates the value of the process. That year, we lost 4.5% versus a 37% loss for the S&P 500.
In 2008, we were hedged at approximately 1,450 on the S&P 500. The market sold off 20-25%, at which point our rules kicked in and we re-hedged the portfolio. What does re-hedging the portfolio actually mean? We sold the deep-in-the-money put option at a very large profit.
We re-hedged the portfolio at around 1,000 on the S&P 500 in the later part of 2008. Even with the market falling from 1,450 to 1,000, we had limited our downside exposure. Just as importantly, re-hedging freed up cash which was reinvested in a cheaper put option – allowing us to add roughly 40% more shares to the portfolio. Markets continued to fall and we were able to re-hedge again in the first quarter of 2009 and add more shares. When the markets rebounded in 2009, we had just bought more exposure to the market at a low point and accounts were mostly positive again by the end of July in 2009. The S&P 500 did not fully recover until March of 2012, when including dividends.
A more recent example shows how we applied the strategy to gold, using the underlying asset of the SPDR Gold Trust ETF, or GLD.
Gold was going through a bear market and in December (2015) the GLD ETF had bottomed near $100. We re-hedged and got approximately 25% more shares for our clients through the bear market, and have since re-hedged again at a much higher price. Gold sold off another 15% or 20%, so our process allowed us to attain more shares and protect profit.
Q: What is your portfolio construction process?
On a macro level, we offer the Defined Risk Strategy on seven different assets, pure plays on each of the previously mentioned asset classes. We let clients choose how they want to allocate among them. If an advisor or individual investor wants a 60% exposure to equities, we would come up with an allocation based on the long-term performance of those assets. We never make market-timing plays on individual asset classes, meaning we would never say we think gold is a better investment right now versus U.S. equities or vice versa.
Q: How do you define and manage risk?
The standard definition always of risk in this industry is volatility, but we do not think volatility is the best way to quantify risk in a portfolio.
Our view is that capital preservation is a much more important way to think of risk. There’s a metric called the Pain Index, which was developed in part by a member of our research team while at a different firm. The Pain Index quantifies how risky a portfolio is by also considering the depth, duration, and frequency of losses.
On an absolute basis, our worst loss in a calendar year was about 5%. We think that is relatively low especially considering that our strategy has outperformed not only its benchmark but also the 60/40 portfolio over its entire lifespan.
We try to limit our losses to a high single-digit loss on an annual basis. Limiting losses during bear markets is a better process, in our opinion, because clients are able to stay in the game. If they don’t experience losses in the first place they are not going to sell at market lows and buy at market highs. They can weather a storm knowing it will not take years to recover. Typically after the low in a bear market, we have been able to break even within months, whereas the market takes years to recover.
