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Where the DRS Fits: How Much DRS is Enough?

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How Different Increments of the DRS Affect Various Portfolios

Once one under­stands and accepts the Defined Risk Strat­e­gy (DRS), the next ques­tions that are fre­quent­ly asked are, “How much DRS should I add to my port­fo­lio? How much is enough? How much is too much?”

There is no blan­ket, one-size-fits-all answer to that ques­tion. Like most things in life, the answer will be “It depends.” What will it depend on?

  • What are the goals and objec­tives of the investor?
  • What oth­er invest­ments exist in the port­fo­lio cur­rent­ly?
  • Does the investor have a par­tic­u­lar view of the market’s direc­tion?
  • What is the risk tol­er­ance of the investor?

These are just some of the fac­tors that one should con­sid­er before invest­ing in any­thing. Still, to help guide the dis­cus­sion, it is worth explor­ing what impact adding the DRS has to an exist­ing port­fo­lio.


The DRS and the Traditional 60/40

We will start out by adding the DRS to a basic, plain vanil­la port­fo­lio that is 60% S&P 500 and 40% Bar­clays US Aggre­gate bond index. The 60/40 ratio is kept con­stant, and we will add 10% incre­ments of the DRS.

60.40 Portfolio Increments of DRS - How Much DRS Is Enough

Source: Zephyr StyleAD­VI­SOR. All S&P 500 data based on his­tor­i­cal per­for­mance of the S&P Total Return Index. All his­tor­i­cal per­for­mance of the Swan DRS Select Com­pos­ite is net of fees. Pri­or per­for­mance is not a guar­an­tee of future results.


The his­tor­i­cal return of the DRS is high­er than that of the 60/40 port­fo­lio and the S&P 500, so obvi­ous­ly, any increase in DRS expo­sure will increase the over­all return.


DRS Improves the Risk/Return Tradeoff

The focus of this exer­cise is on risk reduc­tion or max­i­miz­ing the return-risk trade-off. Risk, when mea­sured by stan­dard devi­a­tion, is min­i­mized with a 50% allo­ca­tion to the DRS. The Sharpe ratio, which is the most com­mon­ly used mea­sure of risk/return trade-off, is max­i­mized at around a 70% allo­ca­tion to the DRS.

Both stan­dard devi­a­tion and Sharpe ratio define risk in terms of volatil­i­ty. There is anoth­er school of thought that sug­gests a bet­ter way to mea­sure risk is in terms of cap­i­tal preser­va­tion. Max­i­mum draw­down, the pain index, and the pain ratio are all ways to quan­ti­fy risk in terms of loss­es. With the DRS’s empha­sis on pre­vent­ing large loss­es, it should come as no sur­prise that the best results for the cap­i­tal preser­va­tion met­rics have a DRS allo­ca­tion in the 70%-80% range.


The DRS and Asset Allocation

Although the 60/40 is often used as short­hand for a bal­anced port­fo­lio, few investors have port­fo­lios con­sist­ing of just large cap U.S. stocks and invest­ment-grade bonds. What if we had a port­fo­lio that was bet­ter diver­si­fied across mul­ti­ple asset class­es and styles? In the next sim­u­la­tion, we add 10% incre­ments to the fol­low­ing port­fo­lio:

Asset Allocation Breakdown - How Much DRS Is Enough

This port­fo­lio is still 60% equi­ty and 40% fixed income, but it is much more diver­si­fied. As before, the rel­a­tive weights with­in the “asset allo­ca­tion port­fo­lio” are kept con­stant as addi­tion­al 10% incre­ments of DRS are added. How does that change the results?

AA Portfolio with DRS Increments - How Much DRS Is Enough

Source: Zephyr StyleAD­VI­SOR. All S&P 500 data based on his­tor­i­cal per­for­mance of the S&P Total Return Index. All his­tor­i­cal per­for­mance of the Swan DRS Select Com­pos­ite is net of fees. Pri­or per­for­mance is not a guar­an­tee of future results.

The results are large­ly sim­i­lar. Adding incre­ments of DRS con­tin­ues to reduce risk and improve the risk/return trade-off across the spec­trum. By most of the mea­sures above, the “opti­mal” allo­ca­tion to the DRS is between 70% and 90%.


60/40 and Asset Allocation Not All That Different

There is a sec­ond, sub­tler point to be made from this analy­sis.

If we com­pare the sim­ple 60/40 port­fo­lio against the more broad­ly diver­si­fied “asset allo­ca­tion” port­fo­lio, we see very lit­tle dif­fer­ence in end results. To the equi­ty por­tion, we added small cap stocks, for­eign devel­oped, emerg­ing mar­kets, and real estate. To the bond por­tion, we diver­si­fied into high yield bonds and cash. We went from two asset class­es to eight, and yet at the end of the day there was lit­tle change in return or risk. If any­thing, the results from the bet­ter-diver­si­fied port­fo­lio are slight­ly worse.

Portfolio Comparison - How Much of the DRS Is Enough

Source: Zephyr StyleAD­VI­SOR. All S&P 500 data based on his­tor­i­cal per­for­mance of the S&P Total Return Index. All his­tor­i­cal per­for­mance of the Swan DRS Select Com­pos­ite is net of fees. Pri­or per­for­mance is not a guar­an­tee of future results.

This table per­fect­ly illus­trates the short­com­ings of tra­di­tion­al asset allo­ca­tion. Sim­ply adding more asset class­es does not remove sys­tem­at­ic, mar­ket risk from the equa­tion. The DRS was built on the premise that mar­ket risk must be hedged away since it can­not be diver­si­fied away.


Rational and Proven Strategy

We real­ize most investors are not going to scrap their exist­ing port­fo­lios and move 75% of their assets into the DRS, no mat­ter how good the his­tor­i­cal num­bers look. How­ev­er, I am remind­ed of the annu­al con­ver­sa­tion I have with my physi­cian.

At every check-up, she encour­ages me to eat more veg­eta­bles. She says every lit­tle bit helps: the more veg­eta­bles I eat, the bet­ter. If she had her way, she would prob­a­bly have me on a 100% veg­e­tar­i­an diet. It’s high­ly unlike­ly that I will ever get to that point, but com­pared to where I was ten years ago, I have worked an ever-increas­ing lev­el of green stuff into my diet. The risk of a cat­a­stroph­ic event like a heart attack was sim­ply too high if I did not make a “real­lo­ca­tion” to a health­i­er diet.

The anal­o­gy to invest­ing is pret­ty straight-for­ward. There is a tremen­dous amount of down­side risk in a stan­dard stock-bond port­fo­lio. With mar­kets near all-time highs and yields near all-time lows, a major sell-off on either side of the stock-bond equa­tion could be cat­a­stroph­ic. We believe that incor­po­rat­ing a “health­i­er” option like the Defined Risk Strat­e­gy into the plan is a ratio­nal, proven way to decrease the down­side risk in a port­fo­lio.


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 Dis­clo­sures:

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 Glob­al Invest­ments offers and man­ages the Defined Risk Strat­e­gy for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. All Swan prod­ucts uti­lize the Swan DRS but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS  prod­uct  offer­ings  will  have  dif­fer­ent  per­for­mance  results  and  com­par­ing  results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997 and are net of fees and expens­es. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The bench­marks used for the DRS Select Com­pos­ite are the S&P 500 Index, which con­sists of approx­i­mate­ly 500 large cap stocks often used as a proxy for the over­all U.S. equi­ty mar­ket, and a 60/40 blend­ed com­pos­ite, weight­ed 60% in the afore­men­tioned S&P 500 Index and 40% in the Bar­clays US Aggre­gate Bond Index. The 60/40 is rebal­anced month­ly. The Bar­clays US Aggre­gate Bond Index is a broad-based flag­ship bench­mark that mea­sures the invest­ment grade, US dol­lar-denom­i­nat­ed, fixed-rate tax­able bond mar­ket. The index includes Trea­suries, gov­ern­ment-relat­ed and cor­po­rate secu­ri­ties, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). 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. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it  325-SGI-080618

By |2018-10-02T11:19:51+00:00May 11th, 2017|Blog|Comments Off on Where the DRS Fits: How Much DRS is Enough?

About the Author:

As Director of Investment Solutions, Marc 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.