The Good, the Bad, and the Ugly

Transcription

1 The Good, the Bad, and the Ugly Quarterly Update of the Swan Defined Risk Strategy A look at the world of managed finance from Durango, CO and elsewhere... CONTENTS From the Desk of Randy Swan THE GOOD, BAD, UGLY Swan DRS 2014 composite performance: 6.52% (Premier) and 6.18% (Institutional), net of fees vs.13.69% for the S&P 500 total return index PAGE 4 DRS INCOME COMPONENT Why does it work? PAGE 5 BULL MARKET OVERDOSE Recovering from a bull market? PAGE 6 UPCOMING STUDIES Interesting asset allocation analysis coming soon PAGE 7 EXCITING ANNOUNCEMENT FTV Capital coming alongside Swan PAGE 7 EMERGING MARKETS DRS The DRS with Emerging Markets equity PAGE 8 Staff Directory The Good The market continued its advance upward in This is now six straight years of positive returns for the S&P 500. I m not sure how often that occurs but the average bull market lasts 3.7 years or 44 months. In addition, there have been between 1-3 bear markets every decade since 1900 with an average decline of 35%. Statistically speaking, it would be very rare for a seventh up year but of course some say that records are made to be broken. I don t know what is going to cause the next bear market. It appears on the surface that the government can keep the party going indefinitely. This is coming from someone who conceived the DRS during irrational exuberance and is always skeptical of changing the natural course of events or natural law. Last I checked, natural law has not been repealed or replaced, which is in my humble opinion, above everyone s pay grade. Of course, bull cycles usually end when things are brightest and most positive and vice versa for bear markets. Virtually no one was calling for the bottom in 2009 when things seemed bleak. We did not even call the bottom on March 10, 2009 even though we re-hedged near the bottom. Cycles usually end when the last bull or bear (depending on the current direction of the trend) throws in the proverbial towel. I m not that guy because, quite frankly, I don t really care when it ends, just that it ends. The reason is simple; the DRS performs better after bear markets. How is that for patience? The oft-quoted saying about the markets staying irrational longer than we can remain solvent comes to mind. We will see. The S&P returned 13.69% and the Swan DRS Select returned approximately 6.52% net-of-fees during On average, the returns were higher for those accounts invested at the beginning of the year. This is a result of adding investments to our composite as the markets moved higher during 2014 (higher price of purchase and higher put strike = lower upside for our composite). Positive returns are always, uh, positive. I realize that you are not supposed to use the word always but I can t think of an exception. This is not to say that we would not like more upside capture in years such as 2014, but we remain disciplined in our approach to seek to realize our long-term objectives of outperforming the stock market on an absolute and risk-adjusted basis over an entire investment cycle. We don t know of a better way and we don t believe there is one. 1

2 Our lack of option income is the main culprit for dampening our enthusiasm about our up capture in In other words, the returns would have been closer to historical upside capture ratios if the return on our income trades was closer to our historical average. This is the second year in a row where our income trades fell below expectations. As seen from the graph below, volatility has been in a downtrend since late 2008, completely different from the scenario in when volatility increased, despite the fact that the markets were increasing. Source: CBOE I mention this because we have just had an almost 75% decline in volatility from December 2008 through the end of If history is any guide, then we can expect another rising trend at some point in the future. Given the 6 year bull market, we should be getting closer, which is why I mention this under the Good. We do, however, get excited about re-hedging at higher levels than the previous year. To remind everyone, we have been consistently raising our strike prices for our hedge every year since March of We re-hedged the portfolio in March of 2009 near 650. The average strike price of the recent re-hedge was 2,000 on the S&P 500. This means that, from a theoretical perspective and after the deductible, most of the gains since 2009 should be protected. Having the market sell-off from 2,000 in the S&P 500 is just as good as from 1,500 as you will see from our analysis on page 6. We primarily care about the magnitude of the decline, not the level. Volatility increasing should be of benefit to our income component and our existing hedge. This assumes that the realized volatility (actual volatility in the market after the sale of premium) is proportionately lower than the implied volatility at the time of the sale. In 2011, Cambridge Associates published a study entitled The Benefits of Selling Volatility that explains this difference between realized and implied volatility and the benefits of taking advantage of it. The study, conducted over a 20 year period from 1990, confirmed this spread between option implied and realized volatility and concluded a strategy of systematically selling out of the money puts and calls on the S&P 500 Index would not have only soundly beaten equity returns with lower volatility but would have also provided better transparency and liquidity than most hedge funds. The study found that in 86.9% of monthly observations, implied volatility was higher than realized by an average of 4.5 points (Source: Cambridge Associates). To remind everyone: the higher the VIX, the higher the premium that we collect on selling the short-term greed and fear (or lottery ticket and insurance as some say). When volatility is low, as it was most of last year, this 2

3 premium can be much lower and the spread between actual and implied can be lower. Regardless of whether or not we generate option income, our underperformance should continue as long as the bull market continues. Of course, our long-term track record of outperformance relative to the S&P 500 should stand indefinitely unless bear markets stop occurring on a regular and consistent basis. The Bad The bad is very simple; our income trades during 2014 were not up to our historical standards. We have waited over the past several years for volatility to increase, but as you can see from this chart from the Options Institute, VIX remained well below the 5 and 10 year averages for almost all of Since the DRS is a rules-based strategy, we are very careful not to shape-fit our strategy to existing markets. The good news is that, at this point, volatility has increased during the latter part of 2014, which should improve the probability of higher income in the future. I have often wished the option income return stream was more like a dividend or coupon from a bond but, unfortunately, the return comes when it comes. As a result of our recent income struggles, we have decided to include a section on how we have been able to historically profit from selling short-term premium to give everyone a better understanding of our theory and strategy. It is important to note our income trades have been positive over the past 3 years (4.8%, 0.6% and 0.2% for 2012, 2013 and 2014, respectively, for Premier). VIX Daily Closing Price in 2014 vs. Long-Term Averages Source: The Options Institute, 2014 VIX in Review The select sector SPDRs equal-weight strategy underperformed by 0.2% in 2014 and 1.7% since May of While the underperformance is bad from a total return perspective, there is a silver lining in that the relative underperformance over the past several years is nothing compared to what it should have been or could have been in a trending market. It has always been my belief, based upon research, that the equal-weight strategy should underperform during trending markets. I would qualify the last 3 years as a trending market. The bottom line is that if this is the best that the cap-weight indices can do during a trending market, the equal-weight strategy should prove even better over the long-term. The Ugly I have two uglies for this version of the GB&U. I am concerned about the significant drop in the price of oil as it relates to the economy. The DRS is not based upon what we think is going to happen on a macro view but this development cannot be insignificant. I believe oil had a similar drop in I do realize from a consumer confidence perspective that $2 per gallon of gas is positive but it is probably not a good sign for the global economy. The other is an article that I read recently that discussed the projected cost of providing those individuals who did 3

4 not previously have health insurance under the new system. The article stated: Obamacare program costs $50,000 in taxpayer money for every American who gets health insurance. The stunning figure comes from a Congressional Budget Office report that revised cost estimates for the next 10 years Government will spend $1.993 TRILLION over a decade and take in $643 BILLION in new taxes, penalties and fees related to Obamacare The $1.35 trillion net cost will result in 'between 24 million and 27 million' fewer Americans being uninsured a $50,000 price tag per person at best The law will still leave 'between 29 million and 31 million' non-elderly Americans without medical insurance Numbers assume Obamacare insurance exchange enrollment will double between now and 2025 Source: CBO January 2015 Outlook on Obamacare, and David Martosko I only bring this up to point out the inability of Washington to create a solution to a problem that is cost effective. This does not bode well for other areas that need attention like entitlement programs, debt, etc. These areas are increasing the risk that an ugly economic scenario could be looming, especially with the rising percentage of the federal budget necessary for debt payment. DRS s Income Component Why does it work? It has always been Swan s thesis, backed up by years of actual historical results, that the DRS has been able to generate returns in the option income component of the strategy for two reasons: (1) risk premium that exists in the options market, and (2) our proprietary risk management rules. This theory is especially important when many in the financial industry and academia believe in the concept of efficient markets. In other words, if you believe that the markets are truly efficient, then there should be no excess return or premium. According to the efficient market hypothesis, expected returns on options trades should be 0, excluding slippage and commissions, absent this risk premium. Regardless, there is a lot of evidence that the options markets allow for such a premium and with proper risk management rules, potentially additional or superior returns. The first component is the risk premium. In simple terms, it means that the implied volatility (which is the market s best guess of future volatility) is less than the actual or realized volatility. In essence, the option sellers demand a premium for that risk (it must be high enough to attract a transfer of risk between those who own assets and those who do not). Collectively, if the sellers do not believe they are being properly compensated for their risk, then the premium won t be sold. Once we can agree that a risk premium has existed and should continue to exist (as shown by the Cambridge Associates study previously mentioned), the question is how to take advantage of this opportunity. There are two general thoughts on how to take advantage of the risk premium: (1) try to determine when the risk premium has disappeared and not engage in option premium strategies during those times, or (2) systematically engage in option premium strategies but with risk management rules aimed at avoiding large losses. Swan has largely depended on the latter, although it does consider the former when entering and exiting trades. 4

5 Recovery from a Bull Market Yes, you read that correctly. The DRS has to recover from a bull market. Of course, not in the sense of recovering actual investment losses, but we do need bear markets in order to outperform the S&P 500 over an entire investment cycle. Just like a forest needs a fire occasionally to start new growth, the markets need to correct the excesses before new growth can occur. I believe the government also attempts to prevent forest fires. Any similarities? As a result, we have developed some analysis to show what the next bear market could mean to the S&P 500 and the DRS in terms of relative performance and to show what size of a bear market would eliminate and possibly create outperformance of the S&P 500 and what it means to annualized returns. It is important to note that our hedged equity portion of the strategy (Basket I) has captured 87% of the upside of the S&P 500 since inception. That is a very impressive number when viewed from a risk-adjusted basis considering the volatility of the hedged equity has been less than half that of the S&P 500, on average. The following charts show the results of how the DRS might perform after an assumed bear market that starts in It is important to note that we have used 0% for the DRS returns, which is less than the average gain in the down years since inception. This would most likely result from generating sufficient income during the decline, as was the case in the most recent two bear markets. The take away from the first chart is that the DRS only needs an average bear market (-35%) to regain 100% of its under-performance since Any large market declines should prove again that over an entire investment cycle the DRS is structured to outperform. Hypothetical Sell-off Analysis - Cumulative Returns Hypothetical DRS vs. S&P 500 Cumulative Returns Start of Current Bull Market (2009) through 2015 Swan DRS S&P % 80.00% 60.00% 40.00% 20.00% 50% Sell-off 45% Sell-off 40% Sell-off 35% Sell-off 30% Sell-off 25% Sell-off 0.00% 20% Sell-off Cumulative Returns % Hypothetical 2015 S&P 500 Sell-off Hypothetical Sell-off Analysis - Annualized Returns Hypothetical DRS vs. S&P 500 Annualized Returns July 1, 1997 to December 31, 2015 S&P % Sell-off 45% Sell-off 40% Sell-off 35% Sell-off 30% Sell-off 25% Sell-off 20% Sell-off Annualized Return since Inception Swan DRS 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Hypothetical 2015 S&P 500 Sell-off These graphs are hypothetical and for illustrative purposes only; there is no guarantee of future performance 5

6 The take away from the second chart is that the annualized returns of the DRS since inception would further exceed those of the market after the next bear market. We have also calculated the hypothetical number of shares gained by a successful re-hedge assuming varying levels of declines in the S&P 500. For example, a 35% decline in the S&P 500 from the end of 2014 should enable DRS investors to obtain approximately 36% more core equity shares internally from the strategy. Hypothetical Sell-off Analysis - Additional Core Equity Shares Purchased from 12/31/2015 Re-hedge after Sell-off December 31, % Sell-off 45% Sell-off 40% Sell-off 35% Sell-off 30% Sell-off 25% Sell-off 20% Sell-off % of Additional Shares Purchased from 12/31/2015 Re-hedge Swan DRS 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Hypothetical 2015 S&P 500 Sell-off This graph is hypothetical and for illustrative purposes only; there is no guarantee of future performance Asset Allocation Study and DRSing Various Assets Although it is well known that Swan believes asset allocation is limited in its ability to protect a portfolio from market risk, there are many advisors that believe in the benefits of diversification and asset allocation. We are completing a study that highlights thirteen popular and well-known asset allocation strategies and illustrates how an allocation to the DRS could have improved these portfolios absolute and risk-adjusted returns. We believe the study will help many advisors in seeing how they can optimize and improve their portfolios. The results might come as quite a surprise to some. Furthermore, we are concluding a study that shows the potential benefits of the DRS with other assets and how the combination of multiple DRS assets could help in building a diversified and hedged portfolio. Look for more info on these studies later this year. 6

7 Exciting Partnership With FTV Capital Newsworthy News Does that phrase sound redundant? I believe that not all news is necessarily newsworthy, but here is the latest you should know about Swan Global Investments. On December 18, 2014, and its affiliated entities received an outside investment from private equity firm FTV Capital. FTV specializes in the global financial services market, specifically asset managers. They have invested in firms such as Financial Engines, PowerShares, ETF Securities, Index IQ, and Velocity Shares, with an impressive track of growth subsequent to their investment. Their investment is not only a vote of confidence on the growth potential for Swan but also on how we are trying to change the marketplace as thought leaders. Swan s mission has always been about creating products that help solve the problem of market risk. is committed to providing the best products to help clients reach their goals and objectives. The reasons for the partnership were to provide: (1) working capital to allow Swan to scale up both its operations and its distribution team, (2) access to FTV s global partner network comprised of some the largest financial institutions in the world, and (3) guidance during this tremendous growth phase of our firm. Swan has gone from 10 team members last July to 21 team members today. We also expect to hire another 4 team members in operations before the end of the 1st quarter. Swan Emerging Markets Fund Our goal at Swan is to apply the same strategy to numerous assets (using the same processes and procedures as our flagship product). Along those lines, we launched a DRS based mutual fund for the Emerging Markets asset class on December 30, Feel free to check it out on our website or give us a call to learn more about it. We have extremely high expectations for this fund and we believe it has tremendous potential due to the inherent high volatility of emerging markets, which is one of the main reasons we chose this asset as our second fund. The potential for a smoother ride in this normally volatile asset might help investors be more comfortable participating in an area ripe with growth potential. We expect to launch several other funds with other assets as the underlying investment by the end of the year to ultimately allow someone to build a portfolio of DRS investment vehicles. The benefit to our clients will be twofold: (1) the ability to create a diversified choice of products with similar risk and return characteristics that seeks to address market risk first and foremost and (2) allow advisors to allocate more of their portfolios to assets that have potential for a higher rate of return but with potentially lowered volatility. 7

8 Staff Directory Main Telephone: Accounting & Reporting Ethan Bates Operations Management Randy Swan President ext. 103 Rob Swan COO Justin Starnes ext. 106 Justin Bates ext. 114 ext. 101 Trading Pat Stiefel Execution ext. 110 Chris Gilman Execution ext. 107 Sales Sean McCaffrey Jamie Atkinson Sales Desk Micah Wakefield Research ext. 115 Compliance and Contracts Jim Engelken ext. 108 Institutional ext. 105 National ext. 112 Regional SWAN ext. 104 Disclosures: Performance results are presented in U.S. dollars, net of management fees, and include reinvestment of dividends and capital gains. Fees may vary based on account size, custodial relationship and other factors. No current or prospective client should assume future performance of any specific investment strategy will be profitable or equal to past performance. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may cause client portfolio performance results to differ from the composite. Different types of investments involve different degrees of risk; we make no assurance that a specific investment will be suitable or profitable for a client s portfolio. Historical performance results for market indices and categories do not reflect the deduction of transaction fees, custodial charges, or management fees, the incurrence of which would have the effect of diminishing historical performance. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurance that it will match or outperform any particular benchmark., LLC ( Swan ) is an independent Investment Advisory headquartered in Durango, Colo. registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act or Being an SEC-registered advisor implies no special qualification or training. Swan Global Investments, LLC, Swan Capital Management, LLC, Swan Global Management, LLC and Swan Wealth Management, LLC are affiliated entities. Further information may be obtained by contacting the company directly at or. Swan offers and manages its Defined Risk Strategy to individuals, institutions and other advisory firms. There are three Defined Risk Strategy composites offered: 1) The Defined Risk Strategy Composite which includes all accounts. 2) The Defined Risk Strategy IRA Composite which includes IRA assets under management. 3) The Defined Risk Strategy Select Composite which includes all non-qualified accounts. Additional information regarding Swan s policies and procedures for calculating and reporting performance returns is available upon request. Swan claims compliance with the Global Investment Performance Standards (GIPS) and has prepared and presented this report in compliance with GIPS standard. Swan investment performance has been independently verified from its inception on July 1, 1997 through December 31, A copy of the verification report is available upon request by calling or ing operations@swanglobalinvestments.com. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm s policies and procedures are designed to calculate performance in compliance with GIPS standards. Verification does not ensure the accuracy of any specific composite presentation. The Defined Risk Strategy Select Composite demonstrates the performance of all non-qualified assets managed by, LLC since inception. It includes discretionary individual accounts whose account holders seek the upside potential of owing stock, and the desire to eliminate most of the risk associated with owning stock. The composite relies on LEAPS and other options to manage this risk. Individual account own S&P 500 exchange-traged funds, LEAPS associated with the ETFs, as well as option strategies based on other widely traded indices. The Defined Risk Strategy Select Composite includes all non-qualified discretionary accounts which are solely invested in the Defined Risk Strategy. The Defined Risk Strategy was designed to protect investors from substantial market declines, provide income in flat or choppy markets, and to benefit from market appreciation. Stock and options are the primary components of the strategy. The performance benchmark used for the Defined Risk Strategy is the S&P 500 Index comprised of 500 large-capitalization stocks, and which does not charge fees. One cannot invest directly in an index. Annualized Returns as of December 31, 2014 One Year Swan DRS Select Net-of-Fees S&P 500 TR Three Year Five Year Ten Year Since Inception 6.52% 9.91% 6.31% 8.40% 9.16% 13.69% 20.41% 15.45% 7.67% 6.89% 8