How ETFs Mitigate Market Risk

Swan Global Investments has been managing ETF portfolios that combine equity exposure with an options overlay for 20 years. The Durango, Colorado-based firm’s approach is resonating with the advisor and retail crowd Swan serves.

In the past three years alone, the firm has seen its total assets under management more than double to $4.5 billion. Marc Odo, director of investment solutions at the firm, gives us the rundown.

ETF.com: What’s Swan Global’s core investment philosophy?

Marc Odo: In the last 20 years, we’ve seen a lot of things happen. We’ve seen the two biggest bear markets since World War II. We’ve seen the second-longest bull market in U.S. history. And we’ve seen all sorts of events like Sept. 11, and the long-term credit blowup.

Through it all, the philosophy for our firm has been the same: We believe that the biggest risk that any investor faces is market risk. It’s the risk that markets are going to sell off by 20, 30, 50%, which, again, we’ve seen twice in the last 20 years.

The traditional risk mitigation or risk protection strategy has been diversification. People say, “Well, you’ve got to diversify your assets, diversify your portfolios.”

That’s a good idea, but the one risk you can’t diversify away is market risk. If you’re invested, you’re going to be exposed to market risk. To us, that has always been a paradox, in the sense that this is the biggest risk people face, and yet standard investment philosophy says you can’t do anything about it.

Our philosophy has always been that if you can’t diversify away market risk, at the very least you can hedge it away. It’s similar to having an insurance policy. You give up a little bit of the upside for peace of mind in down times. To sum up Swan Global in a short motto, it would be, “always invested, always hedged.”

ETF.com: Your flagship portfolio is the Defined Risk Strategy. How does it deliver on your motto?

Odo: Our flagship strategy is based off of large-cap U.S. ETFs. It has a 20-year track record, and it’s been available as a separate managed account that whole time, and also in a mutual fund that’s now five years old. We also apply the same concept to foreign markets—foreign developed as well as foreign emerging—and U.S. small-cap.

Our core beta exposure is passive through ETFs. It’s very difficult—if not impossible—to be a market timer, so we’re always going to have exposure to the asset class, but our protection comes not in the form of market timing but in the form of options.

In the case of the flagship fund, our beta exposure is typically about 90% of our holdings. We have an equal-weight sector approach, using the Select Sector SPDRs. It’s the same thinking behind a lot of smart-beta strategies: An S&P 500-type strategy that’s weighted by market capitalization is guided by the price of a company.

The more the stock price goes up, the bigger the company gets, the more you have to buy. Pretty soon it becomes money chasing hot companies or hot sectors.

The downside of that is times like the dot-com boom. Bubbles inflate. By equal-weighting different sectors, you’re going to get more of a value tilt. It’s not a momentum plan.

ETF.com: And on top of that beta exposure, you have a put options overlay? Options on what underlying asset?

Odo: We buy put options on the S&P 500 for our U.S. large-cap portfolio. In the case of our emerging market portfolio, the core underlying exposure is the iShares MSCI Emerging Markets ETF (EEM), and then all of our put options are on that ETF.

Our small-cap strategy is the iShares Russell 2000 ETF (IWM) and put options on that ETF, and our developed markets is the iShares MSCI EAFE ETF (EFA) and put options on that fund.

When you look at emerging markets selling off by 67% in the financial crisis, it’s a lot of risk, and its hedging out risk makes a lot of sense.

ETF.com: Do investors ever worry that a single ETF portfolio may be risky in and of itself?

Odo: No. Capacity in these ETFs is just so large it’s not really an issue. I would say that would be a valid concern if we did something really specific, like a wind-powered ETF or something, but we choose the broadest ETFs we can get access to.

ETF.com: What does the performance of an equal-weighted mix of Sector SPDRs with a put options overlay look like over time versus a traditional market-cap-weighted mix of these ETFs?

Odo: Sometimes it’s going to work and sometimes it’s not. In 2017, it hasn’t worked that well. It’s been a drag on our performance to the tune of about 2% so far this year, and that’s mostly because most of the action has been in technology, and technology has the largest portion of the S&P 500.

When we have a handful of names and maybe one or two sectors driving the market, it could lead to relative underperformance. That also happened to us in 2015—the year of the FANG [Facebook, Apple, Netflix, Google] stocks, which were essentially responsible for all the performance in the S&P 500. Last year it worked well for us. We added about 200 basis points in relative performance because of energy rallying and tech falling off.

ETF.com: But the differentiator here is the performance in down years, right? It’s meant to hold up better than the market.

Odo: That’s what it’s designed to do. The further the market goes down, the better our strategy performs. That’s when the value of those put-options really kicks in.

Investors are OK to give up some upside for downside protection, but it’s hard to stick to your guns, and that’s been a challenge for us—keeping people focused and reminding them that the bear has not gone extinct. We’re not market timers, but we’re always prepared for that eventual bear market.

Some people who have bought into our fund for the last three, four, five years and have witnessed the S&P continue this crazy run while our fund lags, and they’ve obviously been a little disappointed. But that’s the design. And on the flip side, our assets have gone from $2 billion three years ago to over $4.5 billion today, which tells me people are worried that this market can’t go on forever.

ETF.com: Is there a minimum account where this approach no longer makes sense because it’s too small, and it can’t scale enough?

Odo: From an operational standpoint, our funds are available in mutual fund format, so they’re part of retirement plans, and you can buy them in small increments if you want. But we have this discussion all the time with financial advisors, who might say, “This is a great story. It’s the kind of thing I’m looking for. I’m going to add it to 3% of my portfolio.”

At that point we say, “That’s nice. Thank you. But honestly, 3% isn’t going to move the needle.” For us to protect your portfolio, and really have an impact on the downside protection, we need a significant-enough allocation in the 20-30% range. A lot of people aren’t willing to commit that much, especially from the get-go, or if they think the bear market is still a ways off.

ETF.com: So this isn’t a strategy that can be your only strategy? This is pitched as a complementary strategy to additional ETF portfolios?

Odo: When this strategy was first devised 20 years ago, it was designed as a total portfolio solution. It can be used that way, but realistically, we’ve distributed to a much wider base as part of a solution.

We view it as a core equity with insurance. Some people look at it as a liquid alt, and sometimes as an alternative to fixed income in the sense that fixed income doesn’t have the yield or capital preservation characteristics that this has.

ETF.com: Insurance is never cheap. How much does it cost to invest in these strategies?

Odo: From a performance standpoint, there will be a drag by carrying these hedges, for buying an insurance policy you never cash in. That said, we manage those puts in a very-cost-effective way. We use very-long-term put options. They go out two years. Most people, when they hedge, they use maybe one-month or three-months puts.

All options eventually expire. You get to the use-or-lose point, and if you’re not in the money, “poof,” the option goes away.

The advantage of buying these options two years out is that we don’t hold them for two years; 11, 12, 13 months later, when these options still have value and they’re not expired, we’ll sell out of them and buy new options. We continually roll that hedge so that they never just disappear worthless off our books. That helps mitigate the cost of it.

The other thing is that while our typical allocation is 90% ETFs, 10% put options, if the markets sell off big, the portfolio is going to be more like 70% ETFs/30% options, because the markets have sold off, but that put option is now skyrocketing in value.

We’ll sell that put for a huge profit, re-hedge the portfolio and then we take all those proceeds and put them back to work in the market, which, by the way, has just sold off, so it’s kind of a buy-low, sell-high-type strategy.

Contact Cinthia Murphy at [email protected]