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Magnitude Matters

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Managing Expectations for the DRS during Drawdowns

In this, the sec­ond of three blog posts, we dis­cuss the dif­fer­ent vari­ables that will impact the Defined Risk Strategy’s per­for­mance dur­ing a down­turn.  There are three pri­ma­ry vari­ables that we use to dif­fer­en­ti­ate the down­turns. They are:

  1. The speed of the sell-off,
  2. The mag­ni­tude of the sell-off, and
  3. The dura­tion of the sell-off

In a pre­vi­ous blog post we dis­cussed the speed of the sell-off. This post dis­cuss­es the mag­ni­tude of the sell-off.

Swan has always main­tained that the Defined Risk Strat­e­gy was built to pro­tect against bear mar­kets, not cor­rec­tions. Bear mar­kets are com­mon­ly defined as sell-offs of 20% or more and take months if not years from which to recov­er. Alter­na­tive­ly, cor­rec­tions are sell-offs of 10% to 19%, might last a few weeks or at most a cou­ple months. Bear mar­kets are life-chang­ing where­as cor­rec­tions are quick­ly for­got­ten.


Magnitude of the Sell-Off

The mag­ni­tude of a mar­ket down­turn pri­mar­i­ly impacts the val­ue of the hedg­ing com­po­nent of the DRS. The more the mar­ket moves down, the more valu­able the hedges become. Fur­ther­more, the val­ue of the put options accel­er­ates as they go deep-in-the-mon­ey. The larg­er the mag­ni­tude of the sell-off, the bet­ter the per­for­mance of the DRS’s hedge.

Unfavorable vs Favorable Correction - Magnitude Matters - Swan Insights

Source: Swan Glob­al Invest­ments; hypo­thet­i­cal rep­re­sen­ta­tion


Magnitude and the Value of the Hedge

This rela­tion­ship is dis­played in the graph below. If the hedge is out-of-the-mon­ey, the DRS will like­ly move more in-line with the mar­ket. This is true for both upwards and down­wards moves at this point in the curve. If the hedge is at- or near-the-mon­ey, it will be par­tial­ly sen­si­tive to mar­ket moves. How­ev­er, if the hedge is deep in-the-mon­ey, loss­es in the mar­ket are off­set dol­lar-for-dol­lar by increas­es in the val­ue of the hedge.

Target Return Band Hypo 1 - Magnitude Matters - Swan Insights

Source: Swan Glob­al Invest­ments; hypo­thet­i­cal rep­re­sen­ta­tion


Unfavorable Scenario: August 1998, LTCM.

Dur­ing the sum­mer of 1998 the Russ­ian default trig­gered a cri­sis at the hedge fund Long Term Cap­i­tal Man­age­ment. The mar­ket had been up 23.3% up until that point. Dur­ing the cri­sis, the peak-to-trough loss­es were 19.2% on the S&P 500. While cer­tain­ly a major cor­rec­tion, the LTCM cri­sis tech­ni­cal­ly just missed the 20% break­point to be called a true bear mar­ket. In addi­tion, the mar­ket also quick­ly recov­ered to new highs.

The big­ger impact on the DRS, how­ev­er, was due to the fact that the hedge did not go in-the-mon­ey. Essen­tial­ly, the LTCM cri­sis had erased all of 1998’s gains up until that point; by the time the mar­ket bot­tomed out, the mar­ket was more or less where it start­ed the year. On the way down, the hedge did not offer a lot of pro­tec­tion since it was so far out-of-the-mon­ey. The hedge was near-the-mon­ey when the mar­ket bot­tomed, and its val­ue would have accel­er­at­ed had the mar­ket con­tin­ued to drop. Instead, the mar­ket reversed itself and all of the loss­es asso­ci­at­ed with LTCM had been recov­ered by Novem­ber 23rd, 1998.[1]

Unfavorable Scenario - Magnitude Matters - Swan Insights

Source: Morn­ingstar Direct, Bloomberg

Return­ing to our most use­ful charts, we can see where the DRS was pri­or to and after the LTCM Cri­sis.

Target Return Band Hypo 2 - Magnitude Matters - Swan Insights

Source: Swan Glob­al Invest­ments; hypo­thet­i­cal rep­re­sen­ta­tion


Favorable Scenario: Financial Crisis, Sept 08-Feb 09.

Although mar­kets had been trend­ing down­ward through­out 2008, they plum­met­ed in the last four months of the year. The S&P 500 was at 1,468 at the start of 2008 but fell to 1,193 after Lehman failed on Sep­tem­ber 15th. The S&P 500 end­ed 2008 at 903 but didn’t bot­tom until March 9th, 2009 at 677. The mag­ni­tude of the sell-off in the mar­kets was so great we were able to exe­cute not one but two rehedges. Twice, our put options went quite deep in-the-mon­ey and real­ly proved their val­ue to the port­fo­lio. The DRS was able to sell those put options at a healthy prof­it and re-invest in the mar­ket as the mar­ket was trad­ing at a low point[2].

Favorable Scenario - Magnitude Matters - Swan Insights

Source: Morn­ingstar Direct, Bloomberg

Below we see the Glob­al Finan­cial Cri­sis play out on the tar­get return band. This process occurred twice dur­ing the cri­sis, set­ting up the DRS to per­form quite well when mar­kets rebound­ed in 2009.

Target Return Band Hypo 3 - Magnitude Matters - Swan Insights

Source: Swan Glob­al Invest­ments; hypo­thet­i­cal rep­re­sen­ta­tion


In the third and final blog post in this series we dis­cuss the final fac­tor, the dura­tion of the draw­down.


About the Author

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, 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.





Important Notes and Disclosures

[1] Notes to August 1998: dur­ing the LTCM cri­sis, the har­vest­ing of option pre­mi­um trades also suf­fered. In this high­ly volatile envi­ron­ment, mar­kets whip­sawed up and down, a dif­fi­cult sce­nario for mar­ket-neu­tral trades.

[2] Note to Glob­al Finan­cial Cri­sis: In addi­tion, our option pre­mi­um trades were able to gen­er­ate siz­able returns.

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 non-qual­i­fied 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 Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. 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. 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 www.swanglobalinvestments.com348-SGI-082218


By |2018-10-29T17:12:16+00:00August 23rd, 2018|Blog|Comments Off on Magnitude Matters