Episode #83: Randy Swan, Swan Global Investments, “What Do You Do When Things Are Fundamentally Overvalued, But You Want To Remain Invested In The Market?”

Episode #83: Randy Swan, Swan Global Investments, “What Do You Do When Things Are Fundamentally Overvalued, But You Want To Remain Invested In The Market?”



Guest: Randy Swan is the founder, CEO and Lead Portfolio Manager of Swan Global Investments and the creator of the proprietary Defined Risk Strategy (Swan DRS). In 1997, recognizing the limitations of Modern Portfolio Theory and the difficulty of market timing and picking stocks, Randy developed the Swan Defined Risk Strategy to help investors achieve capital appreciation while seeking protection from large losses.

Date Recorded: 11/21/17     |     Run-Time: 51:23

Summary: The guys start with Randy’s backstory, which leads into why he started Swan Global Investments. In part due to his background in managing liability risk at KPMG, Randy was interested in a way to diversify away market risk. This led him to develop an option-based market approach called the Swan Defined Risk Strategy (DRS), which might be summarized with Randy’s phrase “always invested, always hedged.”

Randy walks us through his DRS methodology, which relies on asset diversification and the purchase of puts to protect against market drawdowns. He gives us more info on the duration of the puts, generally how far out of the money the system targets, and other trade specifics. This dovetails into a discussion of selling options as opposed to buying them. Randy uses selling strategies in an effort to generate positive returns on an annual basis.

Meb asks about the general response from investors, and how they view buying this type of portfolio “insurance.” Randy tells us most people think it makes sense, they just haven’t really been exposed to the idea. Rather, most people are used to hearing only about diversification.

The guys then discuss low volatility in the market. Randy gives us his thoughts, mentioning how now is a great time to hedge a portfolio given the low VIX. The conversation touches on whether you can still sell options in this low-VIX market. After all, it might be dangerous if volatility spikes. Plus, with so many investors having adopted a selling strategy in an effort to generate income, is this space crowded? Does it still work? You might be surprised to hear Randy’s take on it.

This is a great episode for options-fans and investors wondering how to stay in this market while adding some protection to their portfolios. You’ll hear more on volatility skew… the active versus passive debate (and how it misses the point)… Randy’s broad advice for listeners interested in implementing an options strategy… and of course, Randy’s most memorable trade.

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Links from the Episode:

  • 1:27 – Welcome and questions about the impact of Hurricane Maria on Randy’s company which had offices in Puerto Rico
  • 3:09 – How Swan got started and how they ended up in Durango, CO
  • 5:46 – What prompted Randy to start a money management company
  • 7:46 – Randy’s investment philosophy, the Defined Risk Strategy (DRS)
  • 9:35 – What hedging tactics do they implement
  • 12:15 – What kind of targets are they looking at with their hedges
  • 13:57 – Looking at Randy’s option strategy
  • 15:48 – Why does insurance resonate in so many places in life but not in investments
  • 16:13 – Their (Swan’s) Performance the Last 20 Years
  • 18:52 – Exploring their feelings on volatility
  • 19:06 – Swan’s white papers
  • 24:20 – Sponsor: Mountain Collective
  • 25:27 – What’s the best and worst market with volatility being where it is
  • 28:06 – Any shifts in the option strategies over the past 20 years
  • 29:20 – Does the strategy change among different asset classes
  • 30:50 – Option-Based Risk Management in a Multi-Asset World
  • 31:55 – Randy’s offering of multi-asset funds
  • 33:45 – “Passive vs. Active: Losing the Forest for the Trees” – Odo
  • 36:38 – How Randy sees the world today in terms of investment opportunities
  • 38:57 – What market indicators would cause them to deviate from their strategy
  • 41:57 – What type of options they sell
  • 43:31 – Broad advice for trading options
  • 46:07 – Most memorable trade in Randy’s career
  • 48:14 – Ways in which Randy’s thinking on investing has changed
  • 49:42 – Research – US Investors are Expecting 10.5% on their portfolio, Millennials 11%
  • 50:04 – Contact and follow Randy – swanglobalinvestments.com

Transcript of Episode 83:

Welcome Message: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the Co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.

Sponsor: Today’s podcast is brought to you my Mountain Collective. Stop spending your vacation at the same crowded ski resorts. Join the Mountain Collective this winter and you’ll get 32 days of skiing and riding and the word’s best ski destinations, including Aspin, Jackson Hole, and Sun Valley. It’s the perfect pass for skiers and riders with a case of wanderlust and a thirst for adventure. Mountain Collective members get two days of skiing and riding at 16 different destinations. Plus, all your additional days are half off. Look them up online at mountaincollective.com. Again, that’s mountaincollective.com.

Meb: Welcome podcast listeners. Today we have a wonderful show. Our guest is the Founder and Lead Portfolio Manager of Swan Global Investments where he developed and now implements for about 20 years the defined risk strategy. Helped those investors with capital appreciation, also providing some protection against large losses. We got to hang out a little bit in Lake Tahoe. He calls Colorado, Puerto Rico, and now the Bahamas home. Welcome to the show, Randy Swan.

Randy: Thank you. It’s great to be here. Looking forward to a lively discussion.

Meb: So Randy, we got a lot to talk about. One, I’m really excited to hear the origin story of your company, particularly since it’s a little, atypical, and particularly since it was…global headquarters was Durango, but you find yourself today having being been misplaced from the hurricane. How are things going right now? Are you looking to be homeless for a while or are you gonna be back in your home? How is life as a transplant?

Randy: Well, things are pretty good as much as it can be expected. Hurricane Maria came through and actually made landfall in my neighborhood and Humacao, Puerto Rico and Palmas del Mar. So we’ve been displaced since September 20th and so we decided to move the investment management team and the leadership team that was in Puerto Rico to the Bahamas through the end of year. And so we expect the area that we live in to get electricity sometime between now and the end of the year. So our plans right now are to go back after Christmas and get reinstituted back in Puerto Rico. But otherwise, it’s definitely not an experience I would recommend for anyone, but it’s one of things in life you just got to roll with the passes.

Meb: And so if you find yourself in Los Angeles, we got to a spare bedroom and office for you, if you ever need it, but I imagine you’ll be okay. Talk to me about being a kind of fellow Colorado person. I grew up partially there and Durango was one of my favorite places on the planet. But for listeners who aren’t familiar, give us the origin story of how Swan got started, man, it must be 20 years ago now and how you ended up in Durango of all places.

Randy: Sure. It’s actually a pretty good story. So I started my career as a CPA and worked at KPMG and actually Huston. And I decided at 29 that I did want to do something different, and I was an avid investor since a young kid, and I decided I wanted to start a new company and started the Defined Risk Strategy. So I decided to move to Durango, Colorado. I grew up in West Texas so I loved going to northern New Mexico and southern Colorado to ski and backpack and do hiking and stuff like that. So it really was more, you know, enjoyment of the outdoors and what I wanted to do and I felt like, “Hey, if you’re ever gonna start new company, why not go to a place where you can kind of enjoy the outdoors and enjoy the experience of living there?” So that’s really how I kinda joined or went to Durango because I had visited there as a young kid.

I decided, “Hey, I wanna get out of the big city and move to mountains.” So Durango has been a great town. Obviously, our headquarters are still located there. We still run our operations out of Durango and our trading. So it’s a great, small town. It’s a lot of fun, and I definitely miss sometimes the skiing and things like that.

Meb: I spent one spring break while the rest of my friends were down in Cancun or Cabo or something like that. I went to Durango with some friends who do some mountaineering and climb Engineer Mountain one spring and my favorite part of that story was Durango has this awesome old west downtown with this great old-school western bar and right out of like “Deadwood,” and I was the only person that had turned 21 at that time, and all my friends were under 21. But knowing me and typical Meb, I had lost my ID. So as we finished this climb and sleeping in an Igloo underground for like four days, all we wanted was a nice hamburger and beer, and I was the only person that was over 21, but couldn’t have a beer because all my other friends had fake ID’s and could have a beer.

Anyway, Durango is a special place on my bucket list just to go skiing at Silverton right outside of Telluride. Anyway, after that aside. All right, so talk to me Randy, so 20 years ago, give the kinda…what was the, maybe not have even be a plan, but what prompted you to start a money management company, you know, coming out of KMPG? You know, was it just a little idea, little bird at the back of your head? What was kinda the push?

Randy: Well, it’s a great question. I think, fundamentally, I was always an avid investor. Really liked the concept of doing something in the investment community. Obviously, I didn’t come from that exact background, so it was really it’ll get to a point my career where I decided, “Hey, I really wanna do something I love. I wanna try something new.” I really kinda married my experience as an investor growing up with my background at KPMG that worked mostly with insurance companies. And the story always goes back to, you know, what do insurance companies really do? They manage liability risk.

And I said if f someone actually on the investment side can do something similar in terms of, you know, trying to insure or hedge your portfolio and use different levels of deductible retention levels and reinsurance, etc., it really made a lot of sense to me, and so that’s really what I think what needs to be done. There’s not really someone out there solving that problem. And really, our philosophy at the time or the philosophy that I came up with is that the industry has always used modern portfolio theory as the solution to managing market risk, and so, you know, I’ve always said, “Hey, I think that solves part of the problem but not all the problem because you really can’t diversify away market risk.”

So, you know, using options, our strategy is definitely an option-based strategy, that was really kind of the philosophy or foundation of why we started the strategy, why Swan was really created. And I really didn’t have any huge plans. I did not think at the time that we’d be growing to five billion plus, but it was really more, you know, “What will I do with my money?” I managed a small amount of money for friends and family. Had built some CPA clients and stuff like that and said, “This is something that I think will actually…if I could pick one investment, this is what I would do.” So that’s kind of how we started the strategy in 1997.

Meb: All right, so let’s talk a little bit more about your philosophy. There’s two great quotes on your website where it says, “The philosophy is always invested, always hedged.” And I love this Oliver Wendell Holmes quote, “Prophesy as much as you like, but always hedge.” So let’s talk about hedging. Let’s talk about what you guys call the defined risk strategy. Why don’t you give your listeners a broad overview of your framework and what the DRS is more specifically?

Randy: Sure we start from the premise that there’s got to be a better way to manage market risk. So what we try to do is try to take the basic principles of long-term investing which is typically equities. We think equities our great long-term investments, but you’ve got the issues of volatility. How do you deal with volatility in terms of the experience for the end investor? So, that was our basic premise of, “Hey, can you really pick stocks? Can you time the market?” You know, my experience is it’s pretty difficult over long periods of time. So create a path and strategy. And so in the late ’90s, if you remember, we had the dotcom bubble, we had the irrational exuberance speech by Alan Greenspan and yet the market still took another three and half years to pop out.

So, I think, during the late ’90s there was really someone who benefited quite frankly from the ’80s and ’90s as an investor but had gone through the ups and downs. And I’d say, “What do you do when you think things are fundamentally overvalued but you still wanna remain an invested in the market?” And so the concept was very simple, is create a strategy that you can always be invested and always hedge, meaning protect somewhat to the downside. And that’s really what we ran with, waiting for that inevitable dotcom crash that occurred obviously from 2000 to 2002. And so really that was kind of the initial framework is the theory that you can actually have a good experience from investing and try to reduce a lot of that downside exposure.

Meb: All right, so let’s talk a little bit about some kind of more implementation style specifics. When you talk about hedging, what does actually mean? I know you guys use options. Let’s talk about the general kind of broad implementation, you know, and how an investor can think about this and kinda what I means.

Randy: Sure. Well, I go back to our concept about the modern portfolio theory of using different asset classes to diversify, to hedge out some of that risk. And so, you know, our first kind of confrontational point of that would say, “Are you really buying an asset that’s inversely correlated, and is it always inversely correlated?” It’s great until it doesn’t really work, right? Diversification. So, what we ultimately do is we inves about 90% of the underlined and this of course applies to the different asset classes that we do to define our strategy too and then we will buy long-dated options.

And so we invest about 10% of the portfolio in the long-dated put option that we know with a high level of certainty, if the market drops, you know, 20%, 30%, 40%, what that option is gonna do, and that it’s gonna go a long way to protecting a lot of the downside of the market. So that’s the fundamental concept. Obviously, from a compliance perspective, we don’t really go out and talk about it that it is an insurance, but it’s very much like insurance. And we go back to the view of, “Hey, almost everyone insures most assets in their life. Their auto, their house, their health, their life, but why not your portfolio?”

And so we think it’s a much better hedge. The question always comes back to, is it cost effective over the long haul? And that’s great kinda segue into can you really come up with a cost effective way? And so when you get into the nitty gritty of our strategy because we use long-dated options, we think we avoid some of that rapid time decay that occurs as the option goes towards expiration. So there’s a curve, and it’s not a linear curve, it kind of goes off the cliff at the very, you know, last three to six months of an option.

So what we typically do, we’ll hedge something over a multiyear period and then we hedge every year on annual basis. So what it really allows you to do is as the markets are going through a bull markets, we’re able to lock in higher and higher levels on an annual basis and that means sell the original put that you used to hedge the portfolio and buy another put option at higher strike price. And so if I give you an example in March of ’09, we were locked into 650. We had a 650 strike on the S&P, and right now we have a 2,500 strike price put option on the S&P 500. And so that means if the market drops to 1,800 on the S&P that that drop in that price, those put options will largely make up most of the loses in the portfolio.

Meb: And so you don’t have to give away the secret sauce, but are there any ballparks you guys are kinda targeting? Because I know in general one of the cool things is you guys are pretty long-term. I think I remember reading you traditionally targeting a yearly rebalance to the portfolio. Are you targeting sorta at the money? Is it 10% of the money? Is it kind of a dynamic adjustment? How, to the extent you can be specific, any general rules about what’s the kind of sweet spot for you guys?

Randy: Sure. Well, having done this 20 years, I can definitely say that it’s not some absolute rule that’s an add the money option every year. I think we’ve done something from slightly in the money to out of the money. We’ve never believed in hedging, let’s say, 20% out of the money because, obviously, we take that first 20% is worth a lot. So the risk and trade off has always come back to how much insurance do you want and how much…and nothing is obviously for free. So we think something that’s, you know, slightly in the money, slightly out of the money is the long-term goal. And so really what we’re trying to do over a full market cycle is have that hedge pay for itself, and that means that you change the distribution of outcomes. Yes, of course, you underperform for up years, but that bear market comes around like in 2007 or 2009, that it more than pays for itself.

And so I think that just really comes back to how a big of a bear market you actually have. The bigger the bear market, the more potential profit that you actually make on those put options. And at the end of the day you decide you’re going to determine whether that pays for itself. But you definitely have a major lower volatile strategy that allows you, allows clients, quite frankly, investors to kinda stay the course and not sell out in like in March of 2009 scenario.

Meb: And so thinking about it, you guys also, if I remember correctly, do a bit of option writing or option selling as well, partially, potentially to generate income or to just offset some of the cost of the puts. Can you talk a little bit about that and kinda are you doing calls? Are you doing puts? And in shorter term, what’s the kinda philosophy there?

Randy: Sure. So on a broad level perspective in an ideal world, if you do believe that a long-dated options kinda pay for themselves for the full market cycle, then what you’re left with is what kind of income can you generate in various market conditions? And so our goal would be, yes, to be able to generate positive returns on annual basis that either help give you more upside capture ratio in up years and help kinda pay for the hedge in up years and in down years to actually cover for some of the loses. So, I could go through individual examples through the 20-year history where that actually works out, but at the end of the day, yes, we’re selling…because like I said, we like to buy a longer dated option to hedge our portfolio. We like to sell shorter dated options, and that is because of the concept of the risk premium in the market and that is what you systematically would make by writing options on a monthly basis.

So typically, we do a short dated options. They’re out of the money calls and puts that’s typically called a strangle. But yes, we do other types of spread orders. And obviously, this gets into a lot of weird names, things like calendars and butterflies and stuff like. But ultimately the goal at the end of the day is you wanna sell options that are decaying at a much quicker rate than the options you’re using to hedge the portfolio. So, investively, I would say that you’re hedging the hedge, right? You’re trying to offset some of the cost to buy that long-term protection on the downside of the market and, you know, you’re doing that on a systematic basis to try generate income over a full market schedule.

Meb: And so real philosophical question quick and then we’ll get back into volatility and some other good stuff. Having done this for 20 years, what’s the main response from people as to when you were talking earlier about insurance? You know, and thinking about this under the category of, you know, a better risk adjustment returns and, by the way, listeners, you can go look up the gift performance to the strategy that goes back 20 years which you don’t find a whole lot on Swan’s website. But being able to frame concept as insurance, why do you think it resonates so much with people for a house, life, car insurance, and it doesn’t really resonates as much with people on the investment side, or maybe it does? What’s been your experience for the last 20 years talking to investors, advisors on how, you know, they may not or accept this general philosophy as different from insurance in general?

Randy: Well, I think fundamentally people do understand and get that, but I think they traditionally have not being exposed to that concept on the portfolio level. So if you just have a, you know, one-on-one conversation with an advisor individual investor, like. “Yeah, that makes a lot of sense. Why haven’t I heard about this before?” I mean, the industry, like I said, always go back to their solution demands market risk is really diversification. So we’re kinda having the challenge, the religion of the market to say, “Hey, you should invest in different asset classes and you should be kinda be diversified and you just kind of accept some type of efficient rate of return or market return based on the risk level.”

So we do have to kind of overcome some of that with, quite frankly, a lot of the advisors that kind of have adopted that kind of modern portfolio theory as the solution. But I don’t think it’s been that hard. Now, I do think it’s been easier. It’s getting better that there’s more managers, more advisors, more products out there that are going down this path, and I think that’s mostly because of the fixed income environment that obviously 40 of the 60/40 really can’t really hold up to its traditional value in a portfolio that’s, you know, stability of price and consistent income.

So, I think after the 2007 and 2009 selloff, it actually has become more popular, more readily acceptable because I think some of the religions, you know, there’s chinks in the armour of the modern portfolio theory. So I would say it’s gotten easier and easier to really get people and advisors to kind of accept this kind of new view a way of thinking for the reasons we talked about the fixed income as well as, you know, how much did a diversified portfolio really lose in 2008? You know, typically, around 27%. You know, 27% is still a large number.

Meb: Yeah. We’ve done a lot of calls with investors over the past few years, and I think it’s really instructive to think just how much kinda mental and psychological, not just financial but mental and psychological damage, you know, the bear markets can do. I mean, I’ve spoken with to so many investors that just have this trauma from 2000, but more importantly, ’08, ’09, and that have been sitting in cash over since, you know, and they say, “It’s just I couldn’t go through that again.” But anyway, let’s segue a little bit, I mean, when I’m talking about volatility because I feel this is something that a lot of people, it’s in the media a lot, but a lot of people really don’t understand and you guys probably know more about the topic than anyone else.

You guys just put out a new paper, we’ll put links on the show notes called, “The Vanish VIX: The implications of low volatility on the market and the DRS.” Lead author was one of your co-workers, Chris Hossman. But anyway, so let’s talk about it. So we all know that we’re kind of in this low volatility world and you see the headlines with VIX printing levels that it really is rarely, if never, been to. What’s the kind of broad thrust of how does this have an impact on the markets? How can investors think about volatility? And for any investors who haven’t had a chance to read this paper, why don’t you give us a broad overview of kinda how you all think about it?

Randy: So volatility, the VIX, is really the primary gauge of risk measured by the market. And so, technically, they combine a bunch of [inaudible 00:19:52] options and average the implied volatility, and that’s one of the components or inputs to the calculation of an option price. Historically speaking, you’re looking at somewhere around 19% as you alluded to. This year it’s been extremely low. In fact, hit all time low in the upper eights. So, from that perspective, what that says is the market doesn’t think there’s lot of risk right now.

From a contrarian view, I think that’s great for two reasons. One, when you’re insuring your portfolio and no one thinks there’s a lot of risk, that’s the time to be hedging your portfolio probably more than normal. So everything else being equal, the markets, pricing, and we’ll use the hurricane analogy, they’re not pricing in the hurricane at this point. So if you were a new investor from this concept of what we’re talking about at Swan and hedging your portfolio with its low volatility, then everything else being equal, you’re gonna get really cheap insurance. VIX is also one of these kinda metrics that people think is a reversion to the mean kind of product.

So that means that if everything else being equal and volatility is really low, eventually it’s gonna go back to the mean which means it’s gonna increase substantially. And of course, we don’t know when that would actually occur, but if you’re a long-term player like Swan and we have a long-term market, full market cycle view, that means there’s an extra opportunity for you to benefit from that low cost moving to a high volatility environment. So we would get back to that concept of if you were gonna hedge your portfolio right now with put option, well, a little volatility environment is the best time to do that in.

Now we can argue about why that low volatility exist. I mean, I would argue that a lot of set invention and try to keep the party going and not wanting to really upset the apple cart, but at the end of the day, just like the Federal Reserve trying to avoid what happened in the 2007 and 2009 and as well as the dotcom bubble, eventually markets do win out. They’re bigger than the government, I would argue and that it’s a normal drawn out cycle. So the low VIX is I think is a positive right now. Now we can get into the concept of the article about, you know, whether or not volatility, low volatility is good for the option riders. That’s a probably a good question or a good discussion for us to have.

Meb: Keep going, I’m not stopping you.

Randy: Well, okay. So with that low volatility there’s still a lot of opportunities to make income by selling those low volatility options. And so we the concept of, as I said earlier, the implied volatility is what the market is assessing as risk and the biggest key determinant of whether or not you make money by selling short-term premium is really the differential or spread between the implied volatility which is what you get paid to sell an option and the actual volatility which is actually realized volatility which occurs in the future. So if you sell, let’s say, a three-month option or three-month options calls and put, then the biggest determiner to whether or not you make money is what actually occurs after you sell those options, right?

Even if volatility is low, but you have volatility on par with what you’ve sold it at, then obviously you have a good opportunity to make money. And that is what the risk premium concept which is discussed in this paper is that on average, historically speaking, and it’s even true today that the differential between the actual volatility and the implied volatility is usually positively skewed towards selling the premium, selling the options, and making money on a consistent basis. And that means that if you systematically sell options month in month out, you aregonna make some money. And one of the kinda questions right now with all these people chasing deals and engaging in these types of strategies, do those concepts still apply? And I think this year is a perfect year.

We’ve had lower than normal volatility. I know experiences at Swan is that, yes, we’re generating positive returns in all of our portfolios as a result of that differential. And so that is kind of the misunderstanding of the concept of you can’t really make a lot of money if volatility is low. No, it’s really that differential between implied and actual volatility. So those ebb and flow obviously of a market cycles, obviously, as volatility increases over time then that maybe some short periods of high volatility that may make you lose money in those similar short-term options trades, but at the end of the day, that is a consistent profit-generating strategy that allows portfolios to generate some income.

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Meb: I wonder in general, so talk to me a little bit about the sort of strategy in general as far as market regimes. What’s kind of the best type of market? What’s kind of the worst type of market with volatility and prices over the past 20 years? Is there something that’s kind of the sweet spot and something where it’s particularly exposed?

Randy: Sure. Well, there’s really a two-part question because our strategy has a hedging component and an option income component. And interestingly enough, when I said it hedges the hedge, then that means those things are competing, right? So on the underlying portfolio the hedge-to-equity component of our strategy, the absolute best market environment is large moves up or down over a multi-year period. And so I’ll go through the 2007, the 2009 selloff, and although we did not make money, we lost substantially less than the market. I think our drawdown was about one quarter of what the market was, but what it allowed us to do is to sell those deep in the money put options and re-hedge at lower strike price and use that cash, that extra cash, that differential on the cost of the options to reinvest and buy more shares. So this strategy kind of generate cash. It allows you to buy more shares at market lows.

Conversely, obviously, after 2009 bottomed, we were able to ride up a lot of those gains over the next two or three years after that. And so we benefitted from volatility. And I think that will be more pronounced when you look at our gold strategy. We have a strategy on GLB that really it’s been about the only asset class over the last three or four years that we do this for that really has shown a lot of volatility in the underlying assets. So we like volatility a lot and the hedge-to-equity component of our strategy.

Conversely, once again, it’s not so much the actual volatility level that spread between implied and actual that determines that, but everything else being equal, if you were to ask me what perfect strategy or what environment I would want, it would be a high, starting out with a high-level volatility and going to a low-level volatility because as that volatility, as that risk declines in the market, it allows you to make excess profits. And that’s exactly what occurred in 2009 as the market bottomed out and the volatility, you know, was slowly bled out of market. Really starting the year about 40 index going to about 20.

And so interestingly enough that was the biggest year in terms our hedging cost because we started the year at 40. It means we had to pay that insurance premium, but it was also out highest income generating year average. We had double-digits returns that year. And so that shows you the kind of off-setting nature of the different components of the strategy.

Meb: It’s interesting. Is there anything in particular, having done this for 20 years, that you kinda look at markets and see, you know, maybe this time is different as far as structural changes? You know, whether it’d be…you kinda hinted at the advent of a lot more funds in this kind of search for yield. Is there a structural tilt towards option sellers? Is there anything that’s kinds of happened or changed over the past 5, 10, 20 years that you think is a noticeable difference or impact on kind of the way you guys run the strategy?

Randy: So from my perspective, there’s more participants, the market is more efficient. There’s definitely more people out there trying to make some income from selling the short-term premium just as a low-income environment that we’re in right now. But I would say the biggest problem that I’ve experienced over the last six or seven years is just the almost that we had this huge bull market and then over time people start getting antsy that they’re not getting 100% of the upside of the market. That fundamentally causes problems. As any portfolio manager knows is that no strategy works all the time and so obviously you’re kinda counting on a normal full market cycle to kinda work your strategy and see that it actually provides lots of value.

Meb: And you briefly talked about gold. You know, I know you guys run a number of different funds. Is there any takeaways where you say, “Yeah, yeah, Meb, actually in foreign markets you got to think about it differently or in gold you got to think about totally differently.” Are there any differences if people can just apply this sort of strategy across all markets? Or is this something where you wanna actually make some tweaks depending on the different asset classes?

Randy: That’s a great question. I mean, we have the fundamental view of, you know, almost any asset class as long as they have liquidity in the underline as well as the options market is suitable for our strategy. That being said, you know, something like gold is a good example where the volatilities skew and that means that the further out an option is away from the current price of that asset, the higher the implied volatility. That actually helps you in gold. That gives you a higher volatility on the call side which is not normal for most equity markets.

But fundamentally, once again, when you’re buying and selling options, it’s somewhat self-compensating. So if I take something like emerging markets, right? Emerging markets is what I told you want a lot of volatility and asset. Big ups, big downs over long period of time, you would say, “Well, it should cost a lot more to be able to sell that insurance or buy that insurance or that hedge on that portfolio.” But it’s also true that you get it paid back in terms of the higher premium you get on the short-term option that you’re selling.

So I think it’s self-compensating. So structurally, I don’t think there’s anything massively different that we do from one asset to the other. There’s a great research paper that was…I’m not sure who did the actual study but it was engineered by the OIC, the Options Industry Council. And it’s called “Managing Risk in a Multi Asset World.” And they tested 17 different assets and this included all the equity markets, bonds, gold, commodities, you know, oil, stuff like that, and they actually concluded that a strategy somehow to what we do actually on average generated a higher returns with less risk. And there was probably about a third of the assets that had pretty much the same returns with lower risks.

So that’s a good research paper for anyone that’s wondering can this strategies systematically be applied to multiple different assets and get good results? And I think that’s a pretty good independent research paper that kinda shows us this a viable strategy. And of course, this is a much more passive strategy in terms of, you know, kinda like giving example of [inaudible 00:31:39], add the money option one month out every month for five years. You know, what did it mean to buy a six months option to hedge the downsize? You know, just very systematic rules based, no kinda active management in that process.

Meb: So I think one of the cool parts about this strategy in general and the main benefit is that, you know, it can keep the investor invested through the whole cycle, you know, lower volatility and draw downs. And I don’t know the answer to this question, but do you guys happen to run multi-asset funds as well or they’re all typically siloed by asset class where you’re doing stocks and foreign stocks and gold? Do you guys do a combination where you just throw them all into one?

Randy: Well, so the answer is yes, but the way I answer that is that we have is primarily four mutual funds that do the equity market. So we have the S&P, U.S. small cap, foreign developed and emerging markets. We add four, 40x onto that. The multi-asset products are more specialty products like we have the Bermuda Reinsurance Company and then we have the hedge fund that does multi-asset kinda optimization. So, well, we mostly deal with individual investors or advisors, you know, we allow them to kinda come up with that mix that they want to build their portfolio. So we don’t have the 40X fund that’s a multi asset at this point in time. That’s something that a lot of people have always asked about that, but at the end of the day, we wanna give investors options, that they if they really like emerging markets or, you know, S&P 500, we want to be able to get that exposure and get to choose that. So they can always do an option by combining that different mutual funds.

Meb: No pun intended on giving investors options, but it’s the challenge too. You guys have obviously been very successful. Of course, you know, we always struggle with the fine line of ideas and funds that we think are brilliant and then, you know, whether or not investors want them and trying to run a business is always a balancing act. But I’ve told you this before, Randy, but if and when you guys ever wanna launch an ETF I’m more than happy to give you the ticker Swan which it may have expired at this point. I’m not sure. I’d have to look up. We used to have the ticker reserved.

Randy: Okay.

Meb: For other ideas and reasons. All right, well, let’s start to drift a little bit and you guys have another good paper called “Losing the Forest for the Trees” and talking about active and passive debate and how it misses the point. So why don’t we get into that a little bit. You can tell us what is the point then? And we’ll go off on some tangents there, but I’ll let you talk a little bit about kinda the broad themes of this paper.

Randy: Well, the broad themes of the paper after you go through the kinda pros and cons of active versus passive. Obviously, there’s been this huge move towards passive. We’re fine with that kinda view at Swan because we’ve always used, you know, the kinda low-cost tax-efficient ETFs that started obviously SPY in 1993. So we love that concept. You know, our strategy is really built on and based on, you know, not being able to really pick stocks better than the markets can. Of course, the flipside, so the passive is, the active is, you know, there are some managers that over time do outperform the market. So our main view of the paper and thesis of paper is that it’s okay to focus on active versus passive, but if you really miss the point because you really look at an absolute versus relative performance versus a benchmark, right?

So if you take 2008 as an example and you say, “Hey, the S&P went down 37%, can you really pat yourself on the back as an asset manager if you were down 33? I mean, the 4% out-performance, that’s not really not getting you what you want.” So we think that’s the main fundamental problem with the debate, is are you really accomplishing what you want? And I think, we would all agree that, you know, with behavioural finance as it is, you know, your biggest problem as an advisors or an investor is, “Okay, can you stay the course when you go through those bad cycles?” And so, you know, coming up with a strategy that’s more of a total solution is really what you should be focused on, coming up with a portfolio that you’re going to be able to stay the course and get the kinda rate of return that you want over long periods of time.

And so that’s really what Mark Oto [SP] did when he wrote that paper. We think obviously it’s a good concept to bring that attention to people is that it’s not about how you perform relatively, it’s not what you actually make at the end of the day, right? That’s what we’re all investing for in the long-term capital gains and interest in dividends that we can get from our portfolio.

Meb: Yeah, we end up talking alot about it here and from being someone who’s a rules-base quant, it gets frustrating for me because so much of the debate, you know, and the active versus passive. You know, in my mind the passive kinda used to be the phrase that meant something 40 years ago, or 50 years ago, but now it’s been kinda so polluted by you look a lot of these indexes that are just kinda hair brained and kinda really strange and say that’s really not something anyone should be investing in. On the flipside, you can have totally reasonable basic plain vanilla active strategies. So the world and the debate is, I think, not as simple as a lot in the media would like to imagine.

So we started out the conversation with a quote and this is gonna get into the ballpark of gossip, but, you know, we said, “Prophecy as much as you like, but always hedge.” So talk to me about, you know, the way you see the world today as far as investment opportunities and kinda what, you know, you guys are kinda…you don’t have to predict, but there’s this sort of like cocktail hour, have a coffee gossip on kind of the way you see the word as far as asset classes, any other titbits too, you know, the things that you guys think about because I know you’re not strictly quant, though by the way, listeners, we’re gonna link to all of these show notes and they have words like kurtosis and R-squared and linear aggressions out the wazoo, but you can go read those afterwards. But talk to me a little bit about, you know, just kind of the ways are thinking about marketing in general and also is there anything else that’s on y’alls mind, maybe you’re working on, or you thinking about, that’s got you particular excited? Just kinda give you an open mic.

Randy: Sure. Well, I think the biggest perspective is, you know, we’re long-term value managers, so I would say, you more less than a traditional kinda active growth-type manager. So, you know, we look at the markets today in 2017 and say, “Hey, what’s realistic over the next 10 years?” I know this is always debated seems like every day but, you know, we would probably tend to agree that there’s not a lot of upside in the markets because they’re kinda overvalued and I think…I always go back to the concept of how is this big kinda debt bubble, this federal intervention or the central banks around the world going to end? And we think it’s not going to end good, but we don’t know when it’s gonna be bad. And so I would kinda use that right now and say, you know, forecast out 10 years.

But I’m not super positive on the market, but I do know that equities are the best long-term investment. And so from that perspective it goes back to what you originally quoted, “Always invested, always hedge,” not knowing when things are gonna bad and having this systematic approach that allows people to get a good experience in investing is really what we’re about at Swan. And so we’re very comfortable in our skin in terms of being able to stay the course even when we don’t look as good due to, you know, quite frankly, a market that never seems to go down anymore, and that’s something that we’re willing to kinda buy now.

Meb: Is there anything in general, any indicators or any market conditions that cause you guys, particularly to kinda deviate or what Cliff Isings [SP] would call would call “sin a little” when it comes to your strategy? So like, I don’t know, if the VIX is at 80 or if markets hit a P/E ratio of 50 or something where you’ll say, “You know what? We’re going to trim or stop, you know, generating as much an option selling and we’re gonna tilt towards option buying or maybe we’re going to do X, Y, Z.” Are there anything that kinda traditionally plays into that equation or you guys pretty puritan about sticking to kinda the rules of the strategy?

Randy: Well, we always are investing always hedge and that means that we always gonna insure or have options that cover 100% the notional value of the portfolio. So that’s something that we’re pretty adamant about. Now where we would have some subjectivity, and I’ll give you two different examples. One, wpuld be, you know, when we hedge a portfolio which is always, but when we actually re-hedge and that means to sell an option that were using the hedge and buy another one. That is something that, you know, take a time like 2008 and ’09 where we had to re-hedge opportunities.

We try to do get at least every bear market, but ultimately, yes, we in March of ’09 we had to re-hedge the portfolios and we chose to do quite frankly. Very good timing. I don’t think October of ’08 wasn’t your best time to re-hedge your portfolio because you’ll effectively have to pay for another deductible in that option. But there’s some subjectivity in our strategy. We’re not necessarily saying, “Hey, we’re going to re-hedge on December 31st every year or September 30th. And so, you know, our traders and our investment management team are gonna make some hedge to get this. I would just say in March of ’09 to me what we saw was markets making new lows, volatility is topped out and is actually declining.

That was a good indication we were probably exhaustion on the selling side. In terms of the daily trading of the options and selling the short-dated options, you know, our traders are always looking at pops in volatility or quick declines in volatility to either sell new premium or get out of the existing trades. You always have to have a little of both. So in other words what I’m saying on our option income component is that there’s always component of our strategy that’s always gonna be selling premium month in, month out, and there’s gonna be components our strategy that are waiting for those times where, you know, we think the odds are more on our favour than other times, and that is part of our option income component.

And so we always keep some powder dry. We would love to be able to sell when use 80 as an example, that was obviously in November of 2008, and yes, you want to be taking advantage of that high volatility, that extreme volatility, but it’s within the confines of the strategy. So, I think that’s the way I would answerthat questions is we’re not gonna always go out there and decide to hedge or not hedge, but we’re gonna use market weakness as an opportunity to try take advantage of re-hedging the portfolio and rebalancing the portfolio, getting it back to kind of a more normal mix of let’s just say 90/10.

Meb: You may have mentioned this, and I apologize if we already touched on it, are the options you guys are selling is it traditionally straddles, strangles, spreads, nagged? Is there a hard and fast kinda style that you guys particularly lean towards?

Randy: Well, I think our strangles are our bread and butter and that means selling out of money call input. We’re obviously matching it up to the notion of the underlying portfolio and that would be obviously the put options as well as the underlying ETFs. But we don’t just stop there. So we do other types of spread orders and the spread order means using two or more positions that are somewhat offsetting. And so we do other types of strategies, you know, like a butterfly or a calendar spread. And so that is a part of our strategy across the board, like I said, I think that’s more of the opportunistic side of, you know, volatility has popped up to 18 when it’s been at 12 the last three weeks.

We think that’s a good opportunity to take advantage of that. You would take a strategy to something like, you know, certain type of spread strategy that you would employ at that point when you think volatility is kind of topped out and maybe going back down to where it came over the last week or so. So we some of both. You got to be careful of thinking that you’re smarter than the market. And so I go back to the concept of the risk premium, of take advantage of the systematic overvaluation of short-dated options. These are kind of main fundamental belief, and how we take advantage of that is by systematically selling it with occasionally doing some opportunistic selling or buying of spreads.

Meb: You know, it’s funny as you think about this and I cannot fathom why one of our listeners would want to do this on their own, but my co-host Jeff is options aficionado. I don’t know even what word we would describe you, addict? But let’s say an investor said, “You know what, I wanna experiment, you know, with doing this on my own.” Any broad kind of advice for them? I mean, I gave up options trading on my own many, many years ago when of course I learned the lesson that most young people learn which is, you know, blowing up your account by doing a bunch of dumb stuff, but glad I learned it when I was younger and didn’t have much money. But let’s say the people wanted to implement this on their own, any broad advice for the people listening that may wanna kinda do a little bit of this on their own portfolio?

Randy: Yeah, I think there’s kind of two steps or phases to this. So maybe three actually. I think step number one is obviously there’s a lot of option education out there. I think when I started trading options in 1992, I think it was, there was probably like 5 or 10 books out there. It was relatively new. But I soaked it up like a sponge. I read everything. I took these different option courses. But ultimately phase two as you got to start doing something. So I would say, experience, actual experience is necessary and obviously you need to start small. And I think once you go through a multiyear period with ups and down and experience different things it’s…you know, to give you an example, it’s really easy.

One of the first things people do is they sell covered calls or they sell a cash secured puts. And they think, “Oh, my gosh, I can make money for years. This is so easy. This is like printing money.” Of course, people don’t realize that you go through the dotcom bubble that you wake up one day and there tech stocks are down 40%, you know, overnight and that you may not recover from that option position. So, you know, I think the more experience you get, the more you realize what you don’t know, and how hard it is to actually succeed. I think anyone can make money for a while. It’s whether you do it over multiple market cycles.

And then it’s getting back to, you know, once you’ve had some actual experience, I think it goes back to, you know, what fits your kind of mentality. And so I think every investor has to do something that fits their personality and their persona and, you know, the way they kinda work. And so, you know, we’re more into the hedging and generating income. We’re not in speculation side of options. So someone that likes big, big leverage bets, probably is not something that we wanna do and we don’t do in our strategy. So I think fitting the style of option trading with your personality I think is very important for the long-term success.

Meb: I think it’s sound advice. We always ask investors kind of on the podcast one question in 2017, which is funny because the lead-in, and the listeners of the podcast have heard this 10,000 times, so I’m not gonna repeat it. But we always ask the guest, we say, what throughout your career, what has been the most memorable, and it could be good or bad, investment or trade you’ve ever made? And while you think about it, Randy, the reason I laugh is because mine was this options related biotech straddle that I had done in the early 2000s and just maxed out my count because I knew this was a perfect trade, and of course, we all know the result. But thinking back on your last 20, 30 years, anything particularly standout as the most memorable investment?

Randy: Well, I think I’ve got two of them and one would be good and one would be bad to be fair. I think the good one was the re-hedge that we did in March of ’09, obviously, from a timing perspective. We couldn’t have nailed it better. I think we actually re-hedged after a low close. I think my negative is I was involved in some strangles on gold futures, probably in 2007 that set me on a worldwide and we had to adjust and readjust probably, you know, a dozen times before I finally got out of that trade and I looked back and said, “What did I just do?”

So that’s something that wasn’t obviously done in any of our actual products was more like kinda separately managed account for myself, but that was a bad experience dealing with that and having to go through that emotional…not only losing some capital but some mentally draining process, and that just shows you, you know, how big the market is and how complex and you just need to make sure that you’re not highly leveraged. And you learn from your mistakes and you move on that sometimes you can’t always win in all these trades and you need to be modest in your approach.

Meb: You know, and most kinda traders that have been at it for a while and have survived, you know, have plenty of scars where they kinda learn a lesson and it guides the rest of their career. For me, it was kinda becoming a quant because I didn’t want all the subjective kinda decision making. But is there anything that’s kinda you’ve changed your mind on over the past 10, 20 years where you said, “You know, I’ve learned these lessons.” Or, “Maybe this is something that I think is an important,” that’s kinda altered your thinking? Is there anything in particular that over the past few cycles you think stands out?

Randy: So I think that biggest broadest view that I’ve learned is that…you know, and I’ve definitely been a beneficiary of the bear markets of the last 20 years and you always think that people are gonna kinda learn and markets are gonna learn and people are gonna remember what happened, but the reality is they don’t. I mean, we were sitting here talking about the lowest volatility that we’ve ever incurred this year despite the fact that, you know, I think the risks are relatively high. So I think that’s the thing that I take away is that people don’t really learn. Human nature doesn’t change, and you know, people were really burned after 2007, 2009. A lot of people have never gotten back in the market, and a lot of people think, “Hey, load it up. Double down. Let’s get leveraged.” And I think that’s something that’s taken out of perspective of how markets never really seem to kinda learn over time. I think it’s pretty valuable lesson actually.

Meb: Randy, we don’t have bear markets anymore. We’re getting ready to…where this is gonna be kind of a drumroll for the end of the year. We’re getting ready to potentially close out the calendar year first time in history with 12-months up in a row which has never happened before. I think we’ve only had 15 up months. I’ve repeated this the last few podcasts where we talk about a lot of valuations and expectations here and there’s a recent study that came out that said U.S. investors are expecting over…it was like a 10. I can’t remember if it was…I think it’s 10.5% return on their portfolio and millennials were expecting 11.7, which seems a little high. Randy, it’s been a blast today. It’s very thoughtful for you to take time out while you’re displaced. If people wanna follow up, find more information on your firm and everything you guys are writing and putting out, where do they go?

Randy: swanglobalinvestments.com. We’ve got a team of about four or five individuals that are putting stuff out on regular basis, whether it’d be blogs or white papers or research papers. So we give out that stuff for free. We like people to read it and learn stuff, and so I encourage everyone that has any interest in investing or options in general to come to our website. There’s lots of really good stuff and it’s definitely been a fun process. So yeah, go to our website.

Meb: Well, it’s been a lot of fun today. I look forward to catching up with you in Puerto Rico when you’re back in your house or perhaps even in Durango for a beer or a ski. Randy, thanks so much for taking the time today.

Randy: Sure. Thank you.

Meb: Listeners, it’s been a lot of fun. Thanks for taking the time to listen. Send us feedback. Feedback at mebfaber.com. As a reminder, we’ll post all these show notes, white papers from Swan and links to their site. Everything else in the episodes at mebfaber.com/podcast. You can subscribe to the show on iTunes. As always, enjoy it, hating it, whatever, please leave us a review. Thanks for listening, friends, and good investing.