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Worth the Weight?

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Equal Weight Advantages over Cap Weight

As many peo­ple know, the Defined Risk Strat­e­gy is com­posed of three pri­ma­ry ele­ments: the long, buy-and-hold posi­tion in an equi­ty mar­ket, the hedge on that long posi­tion, and the pre­mi­um col­lec­tion trades. Most peo­ple focus on the hedge and pre­mi­um com­po­nents because the DRS’s will­ing­ness to tack­le mar­ket risk via options makes Swan rather unique. But what about the first ele­ment to the DRS, the buy-and-hold posi­tion in ETFs? Is there any­thing unique to dis­cuss there?

With our flag­ship U.S. Large Cap strat­e­gy, we are cur­rent­ly rough­ly equal­ly weight­ing[1] the var­i­ous SPDR Sec­tor ETFs. For the first 15 years of the DRS, we did use the SPY/S&P 500 for our mar­ket expo­sure; how­ev­er, in 2012 we made a switch to this equal-weight­ed sec­tor approach.

 

More Money, More Problems

The ratio­nale for equal weight­ing the sec­tors has to do with the under­ly­ing prob­lems of a cap­i­tal­iza­tion-weight­ed index. With a cap-weight­ed index like the S&P 500 or the Rus­sell 1000, the one and only thing that mat­ters is a company’s price. There is no empha­sis placed on the val­u­a­tion of a com­pa­ny, its rev­enue, its prof­itabil­i­ty, or any oth­er fac­tor.

The prob­lem with this focus is that the more the price of a stock goes up, the big­ger the com­pa­ny gets, and the big­ger the com­pa­ny gets, the more of its stock you have to buy in a cap-weight­ed scheme. This cre­ates a pos­i­tive feed­back loop where the big keep get­ting big­ger; it’s a vicious cycle that may result in a per­ilous bub­ble.

The table below high­lights the top ten names, by size, in the S&P 500. These ten com­pa­nies rep­re­sent almost 20% of the S&P 500. A year ago, it was clos­er to 18%. Half of these names are in tech­nol­o­gy:

 

Top Ten S&P500 Companies - Worth the Weight - Swan Blog

 

This trend has been exac­er­bat­ed by the mas­sive inflows into pas­sive prod­ucts. The table below shows the top five domes­tic equi­ty mutu­al funds and ETFs, in terms of asset flows. The top four are all invest­ed in cap­i­tal­iza­tion-weight­ed indices. Almost $145 bil­lion has moved into these four over the last 12 months, bring­ing their aggre­gate total up to $1.34 tril­lion invest­ed in just these four index prod­ucts.

 

Top Four Cap Weight Net Flow - Worth the Weight - Swan Blog

 

The Bigger the Rise, the Bigger the Fall

This can lead to bub­bles in indi­vid­ual stocks or broad sec­tors. Obvi­ous­ly, the best exam­ple of this was the dot-com boom and bust in the late 1990s. We also saw it in finan­cials pri­or to the sub­prime cri­sis. When the cor­rec­tion came in those sec­tors, it was not pret­ty. The graph below shows the rel­a­tive weights in the GICS sec­tors of the S&P 500 over the last sev­er­al decades.

S&P 500 Equity Sectors - Worth the Weight - Swan Blog

Bear Market Performance - Worth the Weight - Swan Blog

Fol­low­ing the bear mar­kets of 2000-02 and 2007-09, tech­nol­o­gy and finance were reduced to well less than half of their peak weight in the S&P 500. Today, years lat­er, they have yet to ful­ly recov­er to their peak lev­els. While it’s anybody’s guess as to how much longer technology’s cur­rent run will go on, it is accu­rate to say that technology’s cur­rent weight is greater than it’s been since Jan­u­ary 2001.

 

The Value of Equal Weight

Equal­ly weight­ing the sec­tors is a way to reduce the impact the pos­i­tive feed­back loop from the cap-weight­ed approach. As cer­tain sec­tors run, the equal weight approach sys­tem­at­i­cal­ly real­lo­cates to under­val­ued sec­tors. Such an approach is not mak­ing tac­ti­cal calls on the rel­a­tive strength or weak­ness of a giv­en sec­tor. Instead, it is a way of sys­tem­at­i­cal­ly “sell­ing high, buy­ing low.”

Also, equal weight­ing the sec­tors is more of a val­ue, long-term invest­ing approach. One way to think about a cap-weight­ed strat­e­gy is as a “momen­tum” strat­e­gy. The stocks or sec­tors that go up con­tin­ue to attract assets until the tip­ping point is hit and the momen­tum revers­es itself. With the equal-weight­ed sec­tor approach being more of a “val­ue” strat­e­gy, it shuns momen­tum and trends and focus­es more on the long-term val­ue of a com­pa­ny.

Cap vs Equal Weight Manager Performance - Worth the Weight - Swan Blog

Source: Zephyr StyleAD­VI­SOR

The aggre­gate impact on the port­fo­lio is that you have more of a val­ue tilt and less of an empha­sis on the mega­cap names. Some­times this works, some­times it doesn’t. In 2015, when the “FANG” stocks deliv­ered almost all of the S&P 500’s returns, the equal-weight strat­e­gy lagged. How­ev­er, in 2016 equal weight was a pos­i­tive dri­ver to per­for­mance, as sec­tors like ener­gy ral­lied. In 2017, the equal weight approach has trailed the S&P 500 as growth stocks have run cir­cles around val­ue stocks, again led by “FANG”. Long-term, how­ev­er, the equal weight strat­e­gy still appears to be supe­ri­or.

 

The DRS is in It for the Long Haul

Since the DRS is meant to be a long-term invest­ment, the equal weight approach is aligned with our pur­pose. It has always been Swan’s phi­los­o­phy that it is worth giv­ing up some of the upside in order to poten­tial­ly pro­tect more on the down­side. Min­i­miz­ing loss­es is more impor­tant that max­i­miz­ing gains. Obvi­ous­ly, the hedge is the most direct way we man­age down­side risk, but the equal weight­ed sec­tor approach is anoth­er defen­sive aspect of the Defined Risk 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.

 

 

 

[1] The allo­ca­tion isn’t exact­ly equal-weight­ed sec­tors, due to S&P’s deci­sion in 2016 to carve real estate out of finan­cials. This top­ic will be dis­cussed in a lat­er blog post.

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.com328-SGI-112917

 

By | 2017-11-30T15:45:05+00:00 November 30th, 2017|Blog|Comments Off on Worth the Weight?