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Commonly Asked Questions Regarding the Defined Risk Strategy’s Equal Weight Approach

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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, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc 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.com335-SGI-121217


By |2018-10-02T11:07:02+00:00December 14th, 2017|Blog|Comments Off on Worth the Weight? Q&A