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Speed Matters

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Managing Expectations for the DRS during Drawdowns

In the midst of a bull mar­ket, investors tend to for­get that mar­kets can and do sell off. The longer mar­kets go up, the more sur­prised investors are when mar­kets even­tu­al­ly go down. Swan Glob­al Invest­ments believes that it is essen­tial to under­stand and accept that mar­ket down­turns are a nat­ur­al part of invest­ing.

No two sell-offs are exact­ly the same. Over the last twen­ty years we’ve seen the two largest bear mar­kets since World War II as well as numer­ous short­er, small­er cor­rec­tions. While each is a unique event, there are three pri­ma­ry vari­ables that we use to dif­fer­en­ti­ate the down­turns.

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

Dif­fer­ences in these vari­ables will deter­mine how the Defined Risk Strat­e­gy (DRS) will per­form, so under­stand­ing these ele­ments and how they affect the strategy’s per­for­mance is essen­tial for man­ag­ing expec­ta­tions dur­ing the sell-off.

While there might be addi­tion­al “X-fac­tors” that would help or hin­der the DRS dur­ing a sell-off, the speed, mag­ni­tude, and dura­tion of a down­turn will be the pri­ma­ry dri­vers of the DRS’s per­for­mance. This post will look at how speed of a sell off impacts the DRS’s per­for­mance and explain favor­able and unfa­vor­able sce­nar­ios in the strategy’s his­to­ry.

One of the pri­ma­ry dri­vers of per­for­mance dur­ing down­turns is the speed of the sell-off. Mar­kets sell­ing off by 10% in a sin­gle trad­ing ses­sion is an entire­ly dif­fer­ent sce­nario from mar­kets grad­u­al­ly sell­ing off 10% over the span of a month or two. The DRS typ­i­cal­ly per­forms bet­ter dur­ing grad­ual sell-offs rather than instan­ta­neous drops in the mar­ket.

 

Speed and Short-Term Put Options

The impact of the speed of a down­turn is pri­mar­i­ly borne by the har­vest­ing of option pre­mi­um trades. The equi­ty por­tion and the hedge por­tion of the port­fo­lios are lit­tle impact­ed by how quick­ly the mar­kets sell off. If mar­kets do sell-off quick­ly and Swan is forced to close out the short put posi­tions, it might be done under unfa­vor­able pric­ing. Alter­na­tive­ly, if mar­kets are slow­ly “bleed­ing out” it gives Swan the time to make order­ly exits from the short posi­tions.

More­over, the whole process of writ­ing short-term options is based upon their rapid time decay as they get clos­er to expi­ra­tion. In a grad­ual mar­ket sell-off the short options are los­ing val­ue over time any­way.

 

 

Time Decay Image - Managing Expectations - Speed of Drawdown - Swan Global Investments

Source: Swan Glob­al Invest­ments; hypo­thet­i­cal rep­re­sen­ta­tion

In both cas­es, the ele­vat­ed volatil­i­ty lev­els that tend to fol­low a mar­ket sell-off usu­al­ly make future pre­mi­um col­lec­tion trades more prof­itable. This is dis­cussed fur­ther when we talk about the dura­tion of the sell-off. But dur­ing the ini­tial point when mar­kets tip-over, a grad­ual sell-off is prefer­able to a sud­den crash.

 

Favorable Scenario: Gradual Sell Off

In ear­ly 2016, mar­kets grad­u­al­ly sold off over the first six weeks of the year as investors wor­ried about a slow­ing glob­al econ­o­my. Mar­kets bot­tomed on Feb­ru­ary 11th after los­ing 10.27%. In this case, it took over five weeks to offi­cial­ly become a cor­rec­tion. Dur­ing that stretch there wasn’t a sin­gle day where the mar­ket lost more than 2.5%. In this envi­ron­ment, the DRS per­formed quite well, and was down rough­ly a third as much as the index[1].

 

Unfavorable Scenario: Rapid Sell Off

In late August 2015 mar­kets sold off very vio­lent­ly. In the span of just one week mar­kets entered cor­rec­tion ter­ri­to­ry, los­ing over 10%. August 18th and 19th were mod­est loss days, but over the next four trad­ing days mar­kets dropped like a stone. The nadir of the sell-off was Mon­day, August 24th when the Dow dropped 1,000 points and the S&P 500 almost 100 points at open­ing. Although the mar­kets recov­ered near­ly half of their ini­tial loss­es by mid­day on August 24th, Swan’s strict adher­ence to their risk-con­trol rules forced the DRS to close out the short option posi­tion at a size­able loss.

Despite this, the hedge com­po­nent did well dur­ing this peri­od in August. They start­ed the cor­rec­tion slight­ly out-of-the-mon­ey, but the hedge did per­form its intend­ed role as the mar­kets sold off. More­over, in sub­se­quent months the DRS was able to “claw back” some of its ini­tial loss­es. This phe­nom­e­non is explored in the dura­tion sec­tion.

The chart below pro­vides a visu­al com­par­i­son of the ear­ly 2016 cor­rec­tion to the August 2015 sell-off.

Correction Comparison Aug 2015 to Feb 2016 - Swan Global Investments

Source: Morn­ingstar Direct, Bloomberg

 

 

Managing Expectations during a Downturn

Many are on edge dur­ing mar­ket sell-offs and may some­times have mis­guid­ed expec­ta­tions about their invest­ments. Prop­er expec­ta­tions are one of the most impor­tant ele­ments of an invest­ment strat­e­gy and plan because it helps investors keep their cool dur­ing heat­ed mar­ket move­ments and help them avoid get­ting out too ear­ly.

Swan’s Defined Risk Strat­e­gy was designed so that ele­ments of it could pro­tect and poten­tial­ly even prof­it dur­ing mar­ket down­turns. If mar­kets nev­er sold off, there would be no rea­son to hold the Defined Risk Strat­e­gy (DRS).

At the begin­ning of a mar­ket sell off, the DRS will like­ly par­tic­i­pate in more of the ini­tial down­ward move. But this char­ac­ter­is­tic doesn’t nec­es­sar­i­ly apply to the per­for­mance of the DRS over an entire cycle. An investor might look at a week when the S&P 500 is down 5% and the DRS is down 4% and incor­rect­ly assume that if the mar­ket goes down 50% that the DRS will lose 40%. The ini­tial hit is usu­al­ly the worst while fol­low up loss­es are less.

The DRS is con­struct­ed so that if the mar­ket does keep mov­ing down, the DRS’s per­for­mance tends to lev­el off. It catch­es less and less of a down­turn the longer and fur­ther the mar­ket falls.

In a sub­se­quent post, we dis­cuss the sec­ond fac­tor, the mag­ni­tude of the sell-off.

 

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 ear­ly 2016: The DRS also ben­e­fit­ted from the fact that it had just re-hedged the port­fo­lio at the end of 2015, so its hedges went in-the-mon­ey as soon as the mar­kets opened up down in 2016.

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.com. 308-SGI-072618

 

By |2018-10-02T10:50:53+00:00July 26th, 2018|Blog|Comments Off on Speed Matters