Worth the Weight?
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 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:
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.
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.
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.
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, 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.
 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.com. 328-SGI-112917