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Swan Market Commentary —  August 2015 Volatility




key takeaways


The week of August 17th to 21st was a dif­fi­cult one in the mar­ket, with the S&P 500 down 5.7%. Dur­ing the week, the DRS was down, but less than the S&P. As such, we have pre­pared these five key points to help you under­stand Swan’s per­for­mance over the last week. A more thor­ough com­men­tary fol­lows in the next sec­tion.

  1. This mar­ket cor­rec­tion, long over­due, is exact­ly what the DRS was built for. We are pre­pared for this cor­rec­tion and have been cau­tion­ing against one for some time now.
  1. The hedge posi­tions are work­ing exact­ly as intend­ed. The long-term put options are in the mon­ey due to the down­ward mar­ket move­ment. In addi­tion, the mar­ket val­ue of the puts has risen due to increased volatil­i­ty in the mar­ket.
  1. The recent decline of the DRS was most­ly due to unre­al­ized loss­es in our income com­po­nent. The income trades were hurt by the sharp spike in the VIX “fear index”. The VIX more than dou­bled over five days, from 12.83 to 28.03, an increase of 118.5%. This is the largest one-week per­cent­age increase in 25 years.
  1. The neg­a­tive impact of volatil­i­ty spikes tend to be short-lived and lim­it­ed to the exist­ing income trade. We’ve already seen the impact of that. The medi­um-term impact of increased volatil­i­ty lev­els actu­al­ly tends to be pos­i­tive as our income trades take advan­tage of the high­er “fear” lev­els in the mar­ket as high­er fear lev­els means larg­er pre­mi­um.
  1. The Swan DRS has expe­ri­enced these kinds of volatil­i­ty spikes before. There have been short-term loss­es in our track record cor­re­spond­ing to months of large or fast volatil­i­ty spikes, such as the Flash Crash in May 2010 and the Debt Down­grade in August 2011. How­ev­er, in the imme­di­ate after­math of a spike the DRS tends to per­form well while the mar­ket tends to sell off.


Largest Vix spike days since 1990

The DRS has gone through short-term pain many times before, as seen in the table above, how­ev­er the DRS is designed to weath­er short term pain in order to deliv­er returns over the long term. We would like to high­light fur­ther detail for what occurred this past week.


Market Commentary




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:

Dalbar Study - Quantitative Analysis of Investor Behavior 2015

  1. 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.

The approach and struc­ture of the DRS is specif­i­cal­ly built to help investors stay the course through bull and bear mar­kets by rec­og­niz­ing that small­er short­er-term draw­downs are more eas­i­ly weath­ered by hav­ing pro­tec­tion in place for larg­er, steep­er declines. Sig­nif­i­cant declines are part of a full mar­ket cycles and should actu­al­ly ben­e­fit the strat­e­gy when we are able to poten­tial­ly sell the hedge at a sig­nif­i­cant prof­it and pur­chase more equi­ty at a low­er price while also an expec­ta­tion of increased prof­its from our option sell­ing as demon­strat­ed in 2009. The com­pound­ing effect of these addi­tion­al shares along with poten­tial­ly increased income from our options sell­ing in com­bi­na­tion with the sig­nif­i­cant defined risk pro­tec­tion are what dif­fer­en­ti­ate our strat­e­gy from our com­peti­tors. This fea­ture is high­ly desir­able and should be eager­ly antic­i­pat­ed by investors in spite of lim­it­ed loss­es when the mar­ket declines 20%+.

It is impor­tant to remem­ber that port­fo­lios are hedged above cur­rent mar­ket lev­els. In oth­er words, pro­tec­tion is already in place and work­ing to lock in and pro­tect cap­i­tal from a base­line lev­el high­er than the cur­rent mar­ket lev­el. This is what might be referred to as the deductible area of the strat­e­gy and the down­side cap­ture ratio is expect­ed to improve with each suc­ces­sive decline of the mar­ket and ulti­mate­ly cov­er 1:1 mar­ket declines at or near a 20–25% decline in the mar­ket.

bull markets and bear markets










If you or any of your client’s have any ques­tions about the DRS and our process, please don’t hes­i­tate to con­tact our sup­port team at 866–617-SWAN (7926).

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, 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.



Source for VIX and S&P 500 data: CBOE and Morn­ingstar

Impor­tant Notes: 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®). The 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.com035-SGI-082415


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