Commonly Asked Questions Regarding the Defined Risk Strategy’s Equal Weight Approach
In a recent blog post, we made the case for equally weighting the various SPDR sector ETFs to gain our market exposure in the flagship U.S. Large Cap Defined Risk Strategy. Investors frequently have follow-up questions on the equal-weight strategy, which we will address in this “Frequently Asked Questions” format.
Q: Do you equal weight in the other strategies?
A: No. The equal weight is only used in U.S. Large Cap strategies. There is simply not enough coverage or liquidity to implement a sector based approach using sector-specific small cap ETFs. PowerShares released a series of small cap sector funds in 2010, but these were shut down due to lack of interest. Today the availability of small cap sector funds can be described as patchy, at best.
In the international space, the same lack of complete coverage/liquidity on a country-basis precludes us from doing something similar in equally weighting country ETFs. Instead we simply use the big, broad ETFs covering Russell 2000, MSCI EAFE, and MSCI EM for our other DRS strategies.
Q: What are the sectors/ETFs used in this approach?
We use the State Street Select Sector SPDRs ETFs in our sector-based approach. Those ETFs are:
- Consumer Discretionary (XLY)
- Consumer Staples (XLP)
- Energy (XLE)
- Financials (XLF)
- Heath Care (XLV)
- Industrials (XLI)
- Materials (XLB)
- Real Estate (XLRE)
- Technology (XLK)
- Utilities (XLU)
Q: Under the equal-weighted allocation, which sectors are under- or over-weighted relative to the S&P 500?
The precise numbers are always in a state of flux. However, generally speaking, the equal weighted approach tends to overweight Utilities, Energy, and Materials relative to the S&P 500. The underweights are to Technology, Financials, and Health Care.
Q: What impact does the equal-weighted sector approach have on the equity portfolio characteristics?
Essentially this approach gives the portfolio more of a value-tilt. There is also a bias away from the mega-cap names that dominate the S&P 500. If one believes in the “value premium” and the “size premium” that was described in the Fama-French factor models, this approach emphasizes those factors.
In years when growth does better, like 2015 or 2017, the equal-weight strategy tends to lag. In years when value does better, like 2016, the equal weight has outperformed the S&P 500. Also, the equal-weight approach tends to do better in down markets. This is the primary reason for implementing the equal-weight approach.
Looking at the historical track record of an equal-weight sector strategy versus the cap-weighted S&P 500, the overall portfolio tends to have lower risk. Metrics like beta, standard deviation, and drawdowns have been lower than the S&P 500.
Q: Why isn’t Telecoms represented in this sector line-up?
It is true that the S&P GICS structure (i.e., Global Industry Classification Standard) has a separate sector dedicated to Telecoms. However, when State Street was putting together their line-up of sector ETFs in 1999 they encountered a problem. There simply were not enough large cap Telecom companies available to form a viable ETF. There were only about two dozen Telecom companies, not enough to warrant a stand-alone ETF. So back at the inception of the sector ETFs in 1999, State Street rolled those companies into the Technology ETF.
Q: How did you deal with the XLRE carve out?
Prior to autumn 2016, Real Estate was a portion of the overall Financials sector. Under this structure, all nine sectors were truly equally weighted, each having a target allocation of 11.11% of the equity position. The decision by S&P GICS to treat Real Estate as a separate sector, and State Street’s subsequent decision to create XLRE ETF, necessitated some changes to an equal-weight sector approach.
All of the research Swan conducted prior to implementing the equal-weight approach was based on the idea of Real Estate being a subset of Financials. Real estate is not a large portion of the overall S&P. Giving an equal-weight position to Real Estate based upon GICS’s decision would further increase the relative overweights to small sectors and increase the underweight to the major sectors like Technology and Health Care.
Therefore, the decision was made to act “as if the carve-out never happened.” The relative weights of Real Estate and Financials ex-Real Estate is roughly 20%:80%, or 1:4. Within the 11.11% equal-weight allocation, XLRE and XLF are kept roughly in those proportions. The target weights between the two is periodically updated as their relative weights shift.
Q: How do you rebalance the sectors?
With the mutual fund, rebalancing is easy. There have been considerable cash flows into the fund since inception. With the new money that comes into the fund, we simply allocate to the “hungriest” sector (i.e., the sector that is furthest off target). Once that sector is at its target weight, additional monies are then allocated to the second-furthest off target, and so on. In the case of redemptions, the process is reversed: money would be taken from the most overweighted sector until it is at its target level.
Separately managed accounts utilizing the equal weight sector strategy are a bit trickier. Usually there is much less cash flow in an individual account. If, due to market movements, the sector weights within an individual account move too far from target, Swan will actively sell overweighted positions and reallocate to underweighted sectors. There are pre-defined breakpoints around the target allocations that trigger a rebalance. Obviously, Swan is very cognizant of trading costs and doesn’t want to create excessive turnover in the individual accounts via excessive trading.
Q: Do you hedge with the individual sector ETFs?
No. The DRS hedges with SPX options (i.e., options on the S&P 500 index itself) or SPY options (options on the S&P 500 ETF). These options are among the cheapest, most liquid options in the world. Options on the individual sectors or sector ETFs have only a fraction of the liquidity.
So while it is true that there is a bit of a mismatch, or “basis risk” between an equal-weight sector portfolio and the S&P 500, we believe the deep liquidity of S&P 500 options more than compensates for the basis risk.
Q: Why don’t you equal-weight in IRA accounts?
When it comes to option trading, qualified, tax-sheltered accounts are subject to a stricter set of regulations than regular, taxable accounts, or a co-mingled pool like a mutual fund. According to the regulations, if one trades options in a qualified account, the options must be on an underlying position. Due to the relatively smaller size of IRA accounts and the answer to the previous question regarding hedging sector ETFs, qualified accounts are kept simple. The core, underlying investment is in the S&P 500 ETF (SPY) and the options traded on that position are also SPY options.
It is important to remember that the long exposure to the ETFs is only one part of the overall DRS. The buy-and-hold position in the ETFs is, quite frankly, the “boring” part of the DRS. The other portions of the strategy are the hedge and the premium collection trades. These three complementary portions of the portfolio are designed to work in up markets, down markets, and flat markets, respectively. It is for this reason why some commentators have referred to the DRS as an “all weather strategy.”
About 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.
Important Notes and 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 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. 335-SGI-121217