Episode #157: Randy Swan, “Always Invested, Always Hedged”
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 redefine the risk/return dynamic of long-term investing, seeking to achieve capital appreciation while seeking protection from large losses. He is the author of the book, Investing Redefined: A Proven Investment Approach for a Changing World.
Date Recorded: 5/14/19
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Summary: In episode 157, we welcome back our guest from episode 83, Randy Swan. Randy and Meb kick off the conversation by getting into Randy’s new book, and what motivated him to write. Randy talks about having an opportunity to go back and write about how and why Swan operates the Defined Risk Strategy.
In getting into the investing framework outlined in the book, Randy explains why he thinks investors face a “Dual dilemma,” forced to stick with conservative investments, or step out into riskier assets and sacrifice protection from their conservative investments. He goes on to state his thoughts on the evolution of democracy and the role debt has played in decision making in government and central banking.
He then goes deeper into this dilemma by explaining the rationale behind his thinking about this problem, and his expectations for low returns in both equity and fixed income markets going forward.
Meb asks Randy to discuss why it’s so important to focus on avoiding large losses and investor psychology. Randy follows up with thoughts on portfolio construction concepts he feels are important to add to the current thinking to seek return streams that are more in line with investor expectations.
The conversation then shifts into the genesis behind Swan’s flagship, Defined Risk Strategy, the idea that correlation of returns is unreliable, especially in times of crisis, and the difficulty in defining risk in an investment portfolio. He then walks through the portfolio management process and covers some examples of the mechanics during bear markets.
As the conversation begins to wind down, Meb asks in what periods this strategy is expected to shine vs. struggle. Randy walks through the desirable market conditions for Swan’s strategies.
All this and more in episode 157.
Links from the Episode:
- 0:50 – Welcome to the guest
- 1:00 – Episode #83: Randy Swan, “What Do You Do When Things Are Fundamentally Overvalued, But You Want To Remain Invested In The Market?”
- 1:07 – Investing Redefined: A Proven Investment Approach for a Changing World (Swan)
- 1:21 – Strategic Investment Conference
- 2:03 – Episode #156: Steve Glickman, “I Think There’s A Lot Weighing On How Successful We Are At Achieving The Goals Of Opportunity Zones”
- 2:19 – Inspiration behind his Randy’s book
- 3:06 – Why financial headwinds will impact returns
- 6:09 – Thoughts on the 60/40 portfolio
- 8:34 – How 2% bond yields impact portfolio returns
- 11:38 – Importance of investor psychology
- 13:44 – Memorable losses or market events that cemented Randy’s investment philosophy
- 17:27 – The thinking that leads to Swan’s flagship Defined Risk Strategy
- 20:47 – How the Defined Risk Strategy works
- 22:42 – Portfolio hedging and using options
- 27:21 – Managing put options
- 32:30 – Shorter term options and cash generation
- 35:45 – Situations where the strategy shines vs struggles
- 38:16 – Implementing the strategy in investment portfolios
- 40:05 – How the strategy can be applied to other markets/assets
- 43:12 – What new ideas are on the horizon for Swan
- 45:24 – Best way to connect: SwanGlobalInvestments.com
Transcript of Episode 157:
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.
Meb: Hey, podcast listeners it’s almost summertime here in Los Angeles and today we’re gonna have a fun show. We’re welcoming back our guest from episode number 83, CEO and lead PM of Swan Global Investments and author of the new book “Investing Redefined A Proven Investment Approach for a Changing World.” Welcome back to the show Randy Swan.
Randy: It’s great to back Meb.
Meb: So, Randy you spend part of the time in Durango part of the time in Puerto Rico and you’re where right now?
Randy: I’m in Dallas, Texas at the Mauldin Strategic Investment Conference.
Meb: You know, I’ve never attended that one. I’ve always wanted to go, there’s a pretty nice lineup this year. Are you attending, you chatting how’s the lineup so far?
Randy: It’s been great. I’m just attending this year I’m friends with John and I recommended John move down to Puerto Rico a couple of years ago. And actually, I think he moved down to Puerto Rico last fall so I’ve got a new neighbour down there. But the conference has been really good.
Meb: I think I was part of that dinner when we were chatting in a nice Italian restaurant and I was getting to hear all of the details about Puerto Rico. We’re actually having, it will have been published and live by the time this goes live, but a podcast we recorded another second-time guest Steve Glickman talking about opportunity zones. And I think your entire Island now is an opportunity zone there, is that right?
Randy: I believe so.
Meb: It’s gonna be fun to watch how that develops in the coming years. I’m nervously, cautiously optimistic on the opportunity zones any time government sets some incentives into work but hopefully, it has some good outcomes. Okay, all right, man, well, in between the last time we had you on the pod, you went and wrote a book. I wish you’d have let me know because I would have talked you out of it. Book writing is like the most painful experience in my life. Talk to me, what was the inspiration behind putting pen to paper? What was your vision here?
Randy: Well, it kinda goes back to we’ve been operating the Defined Risk Strategy since July of ’97. And really as you do we get to talk a lot about what we do at Swan, and so participating in various conferences and interviews and media events. So, I felt it was a good idea to kind of go back to the beginning of how and why I designed the strategy and what was the investment framework or landscape at that point in time. And just trying to kind of outline my kind of view of the world and why I think we’re in a unique situation right now given what’s happened in the global economies over the last couple decades.
Meb: Well, so I got an advanced digital copy, I read it, enjoyed it. It’s nice to always hear kind of origins story. I mean, you guys have one of the longest track records in the public markets but it’s nice to see kind of the thinking behind it. And I wanna walk through some of…and listeners this book will either be live on Amazon or you can pre-order it depending on when this gets published but again it’s called “Investing Redefined.”
So let’s talk a little bit about the book you know, in the beginning, you start pretty broad you start with the general framework and you have a nice quote we’re talking about monetary theory. Where you say, “With the current bond and equity markets, investors have a dual dilemma do they flock to riskier investments for yield and sacrifice protection from the next bear market? Or do they stick to their more conservative investments losing out on the monumental gains of this raging bull? Simply put given the economic-political-social and financial headwinds we are facing it is grossly unrealistic to expect the kind of returns we’ve seen from 60/40 in the last several decades going forward.” Use that as a springboard jumping-off point, what do you mean there?
Randy: Well, I go back to probably the late ’80s when the Federal Reserve started getting really active in the markets. If you remember the ’87 crash, where I think it was the first situation where the Federal Reserve got really active trying to prevent maybe a worse economic downturn that we had. I think it even really stems on a bigger perspective or maybe a more higher level view of how democracies work right? We start out as a republic and over time democracies evolve and they get more power and they ultimately want more free stuff. They want it easy, they want things to be…work out for them, kind of the age of snowflakes and participation trophies, I think kind of got to the logical conclusion, but my theory has always been that it’s very hard to tell the populace not to spend more money.
And so over the last several decades, I think we’ve kind of built up some debt problems and I think it’s happening not just in the U.S., but globally. I think there’s now $250 trillion dollars of debt globally, and I think that’s obviously a pretty big number and the question is how is that gonna play out? So that kind of goes back to the Federal Reserve getting more and more involved once they got that taste of that power. I think they’ve done more and more become more active over the last couple decades and I think that helped spawn the phrase I always use from Greenspan in ’96 about irrational exuberance right? He made that comment in late ’96 he, of course, helped create that bubble but he was still off by about three and a half years.
And that kind of goes back to, I always use the phrase smartest guys in the room. And even sometimes those guys even though they have a lot of power can’t really control or get it right in terms of market timing. But you know, and that obviously spawned into after the financial crisis lowering rates even further, they’ve done more and more to kind of keep things low and so that’s obviously hurt the bond market right? It’s hurt savers, investors those people have traditionally relied on fixed income to provide stability to their portfolio, as well as consistent income, has really been almost sacrificed to kind of keep the proverbial party going. And so now investors that are traditionally relied on a 60/40 traditional portfolio, will have a situation where it becomes difficult for them to create a portfolio that can help them reach their goals and objectives.
Meb: All right, so you got a couple of competing forces there, some the government, macro force. Talk to me a little more about 60/40 you talk about some kind of range of potential market outcomes in the book, you talk a little bit about Pascal’s wager. But what’s wrong with 60/40? I mean, that portfolio has done exceptionally well not just the last 10 years where it’s beaten pretty much everything, but over the decades. Why do you think it’s not the best place going forward?
Randy: I mean, I think it’s two ways to look at it. One, and the question is what’s realistic returns 10 years going forward for the equity markets, and then the one that we all know for sure is the bond market, right? So if you’ve got traditional returns of 5% or 6% per year historically that’s been pretty average. Now you’ve got much lower returns and so right there you have a problem, and it’s what’s the probability of a bond portfolio delivering 5% to 6% when the yield is much lower than that, and obviously, it’s zero. At zero probability that can deliver the historic returns. So although it’s been having the wind at the back of the bond investor, until recently it’s been a big boom right? And that’s going back to the early ’80s when interest rates were so high.
So I think it’s benefited the investor but that obviously has changed at this point. And that means that the investor has more likely than not either allocated a big percentage of their portfolio to something that’s not gonna generate very big returns. Or looking for other alternative investments, whether it’s increasing their allocation equities or looking at true alternative investments to kind of build out their portfolio.
The other issue obviously is the equity markets. Now that gets a little more controversial from my perspective. Obviously, everyone has an opinion about what the markets are gonna do going forward. That’s something obviously, I can’t really obviously know exactly how that’s gonna play out. But what I do know statistically is I think we’re in a historically overvalued market at this point. So expectations going forward have to be somewhat muted for equities going forward.
So taking those two things together you’ve got probably very low expectations for portfolios going forward. And I think you see that across the whole spectrum of individual investors, pension plans across the board trying to figure out a way to try to get the returns that are gonna reach your goals and objectives. As you probably know, most pension plans have an assumed rate of 7% to 8%, is that 60/40 portfolio, is that really set up going forward to deliver those types of returns? Notwithstanding that it’s happened obviously, over the last 10 years have been a huge bull market. I think the S&P’s up over 425% since March of ’09, that’s just probably not realistic going forward.
Meb: You make two pretty, I think, thoughtful points and you have a table in the book that I think illustrates this nicely and we can add it to the show links. But it’s basically you walk through the first problem which is, say 2% bond yields, be generous you can even say 3%, but somewhere in that range. And the problem with that on a nominal level is that for a 60/40 portfolio even if equities did their historical, let’s call it 9% return-ish or 10% you still only get to about 6% because bond yields are low. So that already disadvantages the investor by the fact that your equities actually have to return something. I forget what the table said, maybe 12% or more based just on bond yields alone adding in the fact of overvaluation makes it problematic.
And you touched on this and I would love to even hear you elaborate more because you probably see a lot of these talking to institutions. People start to move out on the risk spectrum if they don’t think equities are gonna give them 12%, which they probably won’t. They start to move into alternatives and you’ve seen this with everyone and the big one right now is private equity, where everyone expects private equity to be the saviour. When you talk to institutions is that kind of the general feeling as you look around the world?
Randy: Well, I think that’s exactly right and I think the number of 12%, so a 2% yield requires a 12% return on equities to kind of get you to that 8%. So that is exactly what’s going on right now. You know, you’ve got this kind of conflict right now I almost call it tale of two cities, in a sense that you’ve got a raging bull market over the last 10 years in equities, at least U.S. equities. And yet you have a lot of uneasiness or anger that the economy hasn’t done as well. And I think that is obviously a result of big central banks and what they’ve done to kind of goose the market. And so yes, absolutely people are out there looking at everything and everything out there to try to figure out how they’re gonna meet their objectives, right?
And so for the individual person that means when they’re gonna retire, what kind of lifestyle they wanna have when they retire. And obviously, for a pension, it’s looking at how they’re gonna provide benefits to the pensionees in that process. And so they’re all struggling, in fact, I remember going to an alternative investment conference in Cayman in a couple of years ago and that was really the focus of the internal meetings that I was invited to. Is you had all these big institutional investors and they all kind of looked around the room and said, “We know there’s no way we’re gonna be able to reach these goals that we’ve kind of set up…that’s been set up for us given the market right now.” And I think that’s consistently been true and I think that is a direct result of what the central banks have done globally to try to kind of keep things going.
Meb: You have kind of two main problems, you have low bond yields, you have, and this is in the U.S. expensive equity market. I think research affiliates at the end of last year they said that the chance that U.S. equities would hit a historical average return that they have historically, it was 2%, but after the run-up this year I imagine it’s back down to 1% which is what they said prior to Q4.
So not great odds but okay, let’s say theoretically magically stocks and everything else did 12% you got to that historical 8% that all the pension funds and endowments and people are expecting, although most people expect 10%. You have the problem of the path, and I think this is really thoughtful because you outlined this in the book a little bit with your personal experience. And I think so many investors benefit from hearing this and it’s hard to hear it and actually not having lived through it but particularly the young set that hasn’t been through a bear market.
But walk me through the big challenge of a 60/40 is you still at some point lose two-thirds of your money because the portfolio is dominated by equity risk. So talk to me a little bit about the importance of investor psychology, the path that they take to realize those returns and really the importance of avoiding large losses.
Randy: Sure. Well, my experience is that most investors will tell you that they understand it’s a long-term process and they have to weather the ups and downs of bull and bear markets. But in practical reality that’s not usually the way it works out. I mean, it’s very difficult for anyone quite frankly to take, you know, a third loss in their portfolio or greater. And, of course, that’s what happened roughly during the last bear market, I think a 60/40 portfolio just lost about 27% in 2008 alone. So that really potentially messes up your plan, and unfortunately, people use that kind of investment psychology at the wrong times. That behavioural finance really kind of gets in the way of reaching your goals. And I’m sure a lot of people sold out in 2009 and probably didn’t buy back till 2000 and, five years later and get burned.
And so really it kind of comes down to, we think, one of the biggest things is really trying to educate your clients and try to get their perspective right. And try to get them to understand how they’re gonna be able to reach their goals and objectives. And so that risk factor is something that it’s hard for almost anyone to overcome. But that’s what successful investors really are, the ones that kind of stay the course and have a long-term perspective and not make decisions at the wrong time.
Meb: And I like how you walk through it in the book where you kind of repeatedly make this impression. And it’s funny because at this point in the cycle with a lot more risk-taking and a lot less aversion to risk. Were there any particularly memorable losses or market events that seared this into your brain. I mean, I certainly for me, I could list probably 20 that reiterate the importance of how painful it is to lose money. Was there anything that was the driving force behind why this became such a front and centre belief for you?
Randy: Absolutely. Well, I started investing at a pretty early age. I went through the ’87 crash. I went through the 1991 recession in both those times, although the ’87 crash was relatively brief, it still makes a big impact to lose 25% to 30% of your money in a matter of a couple of days or a week. And I think the same thing was true I think in 1991, although I think both those…the recession of 1991 was actually relatively minor at the end of the day. But it was still painful to go to that. So that’s just…it kind of comes back to the industry has a kind of view that hey, what you try to do is you go out there and you figure out, look, here’s the investments that are available in a portfolio and you have to be willing to accept a certain level of risk. And if you put that to work over a certain period of time that’s the way you make your return.
And so it’s really kind of based on Modern Portfolio Theory, right? Which is diversification is really that the main primary solution to handling market risk. And so that’s kind of where we started the Defined Risk Strategy. It was really kind of based on that thesis is that that industry solution is part of the solution but we don’t think it’s all of the solution because you really can’t manage market risk you can’t diversify away market risk. And so that requires some other type of something tool to your portfolio that really allows you to be able to create return streams that are more in line with what I think investors really want. And that is more stable, smooth, consistent returns.
Meb: I thought that was a good example in the book. I wanna make two points here the first being investors minus 2%, 5%, 10% days are all things that have happened in the past fairly regularly. Obviously, the bigger it gets the more rare it is. But just imagine how crazy Twitter would go with we get back to minus 5%, 10% even a 20% down day in stocks, my lord, people would lose their mind. But these things have happened in the past and not having a plan for if they happen again seems rather foolish.
The second point was that in the book you make a great example that I think surprised not just a lot of individuals but also institutions, because the 2008 sort of environment, and it shouldn’t have in my mind, because you had a belief that diversified portfolios, so let’s call it stocks, bonds, global, real estate, commodities, you can’t count on buy and hold markets to be uncorrelated. And you have a couple of great charts in the book that shows correlation is unstable and particularly unstable at times of crisis.
I’m gonna read a quote and then I’ll let you start to riff on some things we can do about it. In the book you talk about “Low-cost passive investing doesn’t address investors greatest fear which is losing money. It only makes the bumpy rollercoaster ride of the markets cheaper to buy. In effect making risk less expensive may actually diminish investors focus on risk thereby replacing risk management with fee management. The main problem with buy and hold is that it doesn’t address investor behaviour. During a bumpy ride, too often buy and hold becomes buy and fold.”
And going back to this 2008 example I think that’s really close to home for a lot of investors we talked to that kind of sold in ’08 or ’09 only to never get invested again. So talk to me a little bit about how a lot of these concepts of the lack of counting on correlation during bad times kind of led you to the genesis of y’all’s flagship, Defined Risk Strategy which you outline in the book.
Randy: Sure, it was really based on that concept of correlation and diversification. Actually, I think most people don’t want return streams to be correlated on their way up, they only want to be correlated on the way down. And obviously, I think it’s almost just the exact reverse, everything kind of seemed to go up together at least in the environment we’re in right now. But then that also means everything most likely is gonna go down together. So just that inability really to be able to define what type of risk you actually have in a portfolio and I kind of go back to what we talked about in 2008 right? The 60/40 portfolio lost about 27%. I think that’s a substantial portfolio. I’m not saying that’s something that people historically haven’t had to deal with and maybe that’s the right way to look at it.
I think our view was acknowledging that you can’t really quantify the risk, understanding that the correlations will not last when you really want them to really be there for you, means it puts you…really a focus on is there a better mousetrap, is there a better way to do it? Obviously, there’s been a huge proliferation of tools over the last 20 to 30 years and that’s obviously the ETF’s and the listed options where I think we kind of come in on the strategy, and is really to take those two basic components of the low-cost tax-efficient ETFs and listed options market, which is…gives the individual investor the ability to be able to kind of, I think, manage risk in a much more definable way.
It really was the genesis of the strategy, having gone through some of those bear markets even though I always said, yes, I’m a long-term investor, it’s still not fun to go through that. So really it was that, and I think going back to the late ’90s of irrational exuberance, right? Watching…I was fortunate enough to benefit from the bull markets in the ’80s and the early ’90s, mid-90s. And then at some point, you say, this doesn’t really make any sense anymore, where people are quitting their jobs to trade stocks for a living. And so that was obviously a very worrisome sign. I think that, and combination of kind of the increasing roles of central banks.
And I kind of make the point also about my view of the central banks historically. And I go back to someone like Greenspan is telling the politicians on a regular basis, you guys need to stop promising free bread and circuses to the populace. You need to stop running up debt. This is terrible, this is gonna be bad in the long run but we’re gonna enable you to keep doing it and we’re gonna make it easier for you to keep doing it and we’re gonna do other things because we’re gonna try to save the day.
I mean, and that’s my assessment of how things kind of built up in the late ’90s, was just an ever-increasing amount of debt and obviously, it’s continued today. And that really said…it kind of put me in a position to say, “Gosh, if I’m a long-term investor, I understand how markets work. But something bigger is happening than just a normal business cycle right now, this is building up to be something, I think a debt bubble.” And here you’ve got the smartest guy in the room, Alan Greenspan saying that I’ve created this bubble myself and what are you gonna do about it? Are you gonna sell everything and go to cash? Are you going to stay the course and just say, “I know it’s gonna be painful at some point but I’m gonna keep doing it.” So that really was the genesis of the Defined Risk Strategy to really…trying to structure those returns and really protect to the downside.
Meb: So for the listeners who aren’t familiar who didn’t listen to episode 83, shame on you. But walk me through the general concept of how this works.
Randy: So the most fundamental view of Defined Risk Strategy is we kind of take some basic principles of, hey, you should invest in things that are tax efficient, low-cost. We like the concepts of equities but we don’t like the volatility involved with equities right? We like the long-term returns. And so we also don’t believe in market timing or even stock selection, right? I think you’ve done a lot of research Meb, about how managers do relative to the benchmarks. And so kind of starting from that concept of not believing in market timing or stock selection using the new tools, right, where ETFs and listed options really create a strategy to be able to do that.
So what we do is we would say, “We’re fundamentally agnostic as to the underlying.” And that means the underlying equity portfolio and so we’ll take an equity portfolio, in our example the S&P 500 is our kind of flagship strategy, that we started in ’97. And we invest roughly about 90% in the long ETFs whether that’s through FTY, which is the original ETF or the Select Sector SPDRs. But we also do the exact same strategy on emerging markets, foreign-developed U.S. small cap. So we invest about roughly 90% of the underlying portfolio in the ETFs, it’s a buy and hold. Then we invest in long-dated put options to be able to hedge out most of that market risk.
What I try to tell people about the options is, kind of goes back to the concept of you have to decide what you wanna protect and what you have to be let go. And I think we always go back to we’re trying to protect against large bear markets, large losses in an investor’s portfolio, not necessarily market corrections which usually takes several months to recover from. So on a broad level it’s taking equity position, it’s hedging it with long-dated options and it’s, the third component is selling short-dated options try to generate income to help pay for the cost of the hedge in some market conditions.
Meb: So listeners let’s talk a little bit about that because there’s some key distinctions I think you made that are important. The first listener takeaway probably is hey, okay, well, if you just had the S&P obviously there’s no free lunch so if you just buy a bunch of puts that’s gonna come at a cost. And so I imagine the first question from listeners would be how much is that costing me to own that sort of insurance?
And then the second would be what’s the actual…because you disclosed this in the book, so, which is pretty amazing. What’s the actual process when you say long-term what does that mean? Are you updating these once a week? Like, how does the general flow work and kind of conceptually why does it work? In a world where mostly, markets are efficient.
Randy: Absolutely. Well, I think we start off from the concept, I think everyone would agree if you could come up with a cost-effective way to hedge your portfolio who wouldn’t want to do it? It would allow you to invest more in equities. So I think the fundamental question is, can you do it cost effectively? And we think the answer is yes. But how we do that I guess is part of the process we’ll get into a minute.
But fundamentally what I would say at the end of the day is it depends on…how much that costs depends on what the normal, let’s just call it bull market cycle, and that includes a bull market and a bear market, right? So we started the strategy in ’97 if you kind of break our track record up into groups, you had a bull market a bear market from ’97 to 2002. And then you had another bull market from 2003 and then obviously, the 2007 to 2009 sell-off. And so the reality is those first two cycles we actually had the put options actually become a profit centre, they actually made you money and obviously, that’s because you had larger than average bear markets.
And so fundamentally the first concept, I’d just say is depending on the up move and the down move determines whether or not you can make money, even in an efficient market. So put options are priced on what people’s expectations of what the market could do over that time frame. So if you’re typically hedging your portfolio in a time period where people don’t think that the proverbial storm is gonna come, then obviously it’s cheaper. And if you’re buying insurance in a market environment they that the storm is gonna come it’s gonna cost you a little more money.
Fundamentally, we believe that it’s a worthwhile process because it really allows clients to stay invested for the long haul. So we always use the phrase “always invested, always hedged.” And that takes away the market timing aspect of that, so you asked about the length of time of the option. So what we’re pretty fairly open about in our strategy is that, and we are very unique in this respect, is that we do hedge with long-dated options. And so the concept of that comes down to if your strategic nature in how you use options, meaning we’re always gonna be invested, always be hedged, you’ve got to come up with a cost-effective way to hedge it’s not a Pascal timing tool to say, “Hey, I think the market’s gonna top out this quarter, I’m gonna hedge for the next six months to a year.” We think that’s actually pretty difficult to do if not impossible, therefore we have to be committed long-term to come with a cost-effective way to hedge.
So long-dated options give you two benefits over short-dated options. One of those is that the time decay that occurs in a long-dated option if you don’t hold it to expiration, is actually much lower than trying to buy put options on a, let’s say a 90-day basis right? Every quarter.
The second benefit of using long-dated options and you think about it, is that even if you bought a put option and you had the foresight in, let’s say July 1st of 2008, saying, I think we’re gonna lose a substantial amount of money in the markets over the next six to nine months. Let’s say you were to go out and buy an option that expired at the end of the quarter in September, and so the put option did what it was supposed to do it protected you on the down movement in the market, but guess what? You’ve now got to insure your portfolio starting in October. And so it doesn’t matter how much money you made on those put options when the market went down in third quarter you were now gonna have to go out in the market and pay up. And that means the market would be priced in that volatility in the market, they would be pricing that risk. So you’d actually have to go out and by the proverbial portfolio insurance when the market’s in chaos. So it becomes almost cost prohibited by short-term insurance when the market’s doing what it did in 2008. That’s another reason why we’re committed to the long-dated options.
And so what we typically do is buy them roughly around two years to expiration and hold them about one, and then we trade them up for another two-year option, so we’re always rolling. And so that means that when that volatility event occurs we’re able to get paid for the options that were long, that we hold in the portfolio when we’re simultaneously buying new options that prevent us from getting stuck in a situation where we really can’t insure our portfolio.
Meb: Okay, there’s two parts I want to ask. One is you talked about I assume you don’t just buy and hold the equities, buy a bunch of LEAP puts. And by the way, talk a little bit about you doing in the money, out of the money. And then second is do you just buy a bunch of puts Jan 1 go take a nap till New Year’s Eve the next year? Or do you have to constantly monitor those and kind of what you’re thinking around how to think about adjusting that portfolio?
Randy: So I think you asked two points. The first one is how do we actually manage the put options? And so, effectively what we’re trying to do in the portfolio is take a arbitrary length of time and we’re gonna say a year and say set that clients expectations for that year and say, “Look here’s how much risk you’re gonna have in a portfolio for the hedged equity component of the strategy.” And so we’ll typically do that in the high single digits over a year basis. So that kind of sets the client’s expectations say if the market drops 20%, 30%, 40% you should have something in the high single digits. And so that really goes to probably something at the money or very close to the money. And obviously the further it’s fixed that you can go in in the money that obviously is gonna cost you more but it’s gonna give you more downside protection.
So that’s really you know, if you were doing this on an individual basis which is part of our overlay strategy that we customize for larger portfolios. You can have that kind of interaction and say, “Hey, I want more protection or less protection.” In fact, one of our five mutual funds is a more growth-oriented fund that has less insurance in the portfolio. So that just comes back to people’s preference about whether they wanna be more aggressive or not aggressive.
But getting back to the management of the entry or trades is really what we’re hoping for during a bear market is to be able to take advantage of that market weakness by selling those deep in the money put options. And so I’ll go through ’08 and ’09 as the actual examples of what we went through and how we managed those portfolios. So most people remember that the S&P was around 1,450 to start 2008, we had a pretty big sell-off starting in the third quarter. We at one point on October 8th, I think the market was down roughly 25% for the year. We sold those put options that were deep in the money at that point, re-hedged the portfolio and that means buying another put option that’s close to at the money, and using that excess cash to buy more shares. And so how do you generate excess cash, an option that’s deep in the money is gonna be worth more than an at the money option, and so that differential gives us cash.
So this strategy actually generates cash during bear markets to really be able to add to your underlying equity portfolio. So our clients got roughly 40% more shares during the sell-off in 2008. And so the first question people ask me is, “Well, how did you pick that point?” We picked a point not necessarily based on time it’s really based on market movement. So it’s really not to your advantage to try to hedge or re-hedge the portfolio every 5% sell-off or even 10% sell-off. We’re really looking for more of the 20% to 25% range. And the reason why that is is that, roughly at the money option when it goes 20% of the money is where those put options are really paying off almost virtually one-for-one for the decline in equity. And so really trying to bring that 90/10 split, 90% equity 10% put options, that now let’s say has become 60/40 back to that 90/10.
And so that’s a decision that we’ve made to try to take advantage in that sell-off. Of course, that was not the low in the market, still had the protection in place albeit we had to pay another deductible, effectively by rehedging the portfolio, but getting into new shares for long hauls, is something that’s benefited us. And then roll forward to March of ’09 once again market had sold-off substantially from the most recent rehedge. We bought new put options, sold the old in the money options, and it had a substantial number of shares for our clients in March of ’09.
Now, of course, we all know that was below in the market, that wasn’t necessarily a timing call by Swan. But our kind of rules dictated that a 20% to 25% sell-off from the most recent rehedge is really kind of what we’re looking for to take advantage of that rehedge process.
Now, everything else being equal we’re trying to rehedge the portfolio. We really want the portfolio to kind of run for the year up or down and then establish the position. And then as the market moves up towards the end of the year then we’re gonna want to lock in as many of those gains as possible. So our rehedging process on the upside is much more stringent because statistically speaking, I’ll use last quarters as a good example, I think that was the first year out of 70 years where the market was up 10% or more during the first three quarters and actually ended up being down for the year. Before last year you’d be 0 for 70 to rehedge.
So we really try to avoid trying to rehedge on up years during the market because the more you rehedge the more flat your portfolio becomes. In other words, you become more delta-neutral. Which means that for every dollar the market goes up you’re gonna make less money than if it was the market had moved away from your strike price of your options. So we try to avoid a lot of rehedging on the upside during the year. But it is an active process, it’s also trying to figure out where we’re gonna get the most bang for the buck in terms of strike prices and managing that rehedge process on an annual basis.
Meb: Talk to me about the third leg, so you have the long equity, you have the long-dated puts. Talk to me a little bit about how to think about some of this income generation from selling shorter-term options. Whether to be seen as reducing the cost or however you wanna frame it, how does that play into this strategy and how do you think about constructing that leg of the stool as well?
Randy: Absolutely. Well, the concept of selling short traded options is something that is very popular in the markets nowadays. We fundamentally, as I mentioned earlier believe that you should hedge using long-dated options and if you understand why we do that, we talked about the rate of decay as an option goes towards expiration is exponential. That means a option that’s 90 days expiration is gonna decay at a much quicker rate than something that’s let’s say a year out. So if I told you I didn’t wanna hedge using long-dated options that means I probably want to sell short-dated options due to that rapid time decay. So we’re trying to take advantage of what it is called the risk premia in the options market and that means that the market kind of pays you on average for taking that risk. And what that means is, is that the implied volatility which is one of the components of the option pricing model, what the market perceives to be the volatility expectations going forward, on average, is higher than what’s actually ultimately realized in the market. And so that spread allows option sellers to make money. Now, of course, that doesn’t happen every single month, every quarter, but on average that’s what has been how huddled up to the last several decades in the options market.
So that’s the first step of our option income component. Our second step is that’s where we do really most of our active management and what that really means is kind of determining on the front end how we’re gonna manage those options. So what we’re really trying to do is avoid large losses. So just like a put option is gonna protect you on the way down if you’re using it to hedge your portfolio, we sell short-dated options to try to generate income. And so what we have to do is actively manage those, that means if the market makes us substantial move down we would…may have to take off that position or make adjustments to try to maintain the integrity of the put option that were along to protect the portfolio. So we’re actively managed on those type of income trades.
Now, some people ask me, well, why would you wanna do that, seems like you’re kind of undoing it. But if you stick to a disciplined process of selling options on a monthly basis it makes a lot of sense that it will generate income. And so really at the end of the day, I think I mentioned earlier in the podcast that depending on the size of the bull and bear market you may get a put option that actually makes you money over that full market cycle. But let’s assume it doesn’t for a second, to be able to consistently generate income in your portfolio really allows you to have a less of a loss that we had, like, in 2008.
I think that our equity portfolio or hedged equity portfolio would have lost about 10% in 2008. But we made about 5% income so our net loss in 2008 was about 4.5%. Vice versa on the other side or the flip side is if you have an upmarket and you’re able to generate income then you’re gonna have a higher upside capture. And that’s really kind of the gain at the end of the day is trying to generate a strategy that has the right combination of upside and downside market capture that allows you to outperform the market. But also just as important is to give the investor a better experience and really prevent them from making bad decisions at the worst time.
Meb: All right, so the people listening, I got another two-part question. The first is when could investors broadly speaking expect this, I mean, you mentioned down 5% in 2008. I think every person on the planet would have taken that for equities. When can you expect this strategy to shine? And when can you expect it to struggle? Are there particular markets where the DRS does exceptionally well? And what are the most challenging ones too?
Randy: Well, we shine obviously during bear markets because we should… [inaudible 00:36:16] outperform the underlying market. We should do reasonably good in a kind of a flat to gently rising market but know that we’re not gonna get 100% of the upside. And I think what…I could go back to that combination of the upside-downside really is what determines whether or not you outperform the market.
More and a different way to look at it is, I always tell people, when you look at our hedged equity, it’s almost kind of very similar to a straddle in the sense that if you ask me right now if I could look out three years would I want the market to be down 60% or up 60%. I probably would choose down 60% because of our ability to get additional share that sounds a little weird even though we’re long equity to say that. So what we really want on the hedged equity component strategy is really the market to move up a lot or down a lot, because we’re able to lock in those gains by using higher and higher strike prices on the put options. And I think in March of ’09 we were using 675 puts and now we’re using 2,800, 2,900 puts and that means that a lot of those gains that we’ve made over the last decade have been locked in.
So, on the hedged equity portion, we want a big mark that moves up or down. On the income trades we want markets to stay within a normal defined range over, let’s say, a monthly period and why is that? And that goes to what makes us have the most difficult time is when you have high levels of volatility in very short periods of time like the flash crash, like the downgrade of the U.S. debt, things like 9/11 right? Those are all events that have occurred since we’ve been operating the strategy and so why is that? Because obviously, we should be losing money on those option income trades because we are gonna have to take off those positions and most likely incur losses.
And so that’s really the worst type of environment and I think it’s not even just going down it’s going up and down and I can use last January, February of 2018 is a good example. If you remember in January I think the market went up 7% in the first three weeks of January and then proceeded to lose it all and then some. Those types of whipsaw markets option-income strategy makes it very difficult to generate income, in fact, we would lose money in those types of environments.
Meb: So as an investor thinks about this strategy everyone, many people I shouldn’t say everyone, loves to place their investments into buckets. And what is the traditional way you see advisors or institutions or individuals thinking about a strategy like this? Is it an equity replacement? Is it a bond replacement? Do they put it in satellite? How do they kind of think about this traditionally and how should they?
Randy: I’ll answer the first how should they, and then how I designed strategy in the first place when I designed it back in the late ’90s was really to kind of replace the 60/40 portfolio. If you think about that, we went back to what was kind of the light bulb idea was I don’t like the fact that I have to go through and lose a third of my money every five years. I also don’t like the not being able to count on the correlations working in the right way. So fundamentally if you took this one strategy on the S&P 500 it would be a good way to replace your portfolio.
Now, obviously most of the people we’re dealing with, they’re not gonna go 100% on any one investment or any one strategy. That’s where it goes to I think how we’re used. I think we’re really used across the board to me my view is, is that if you have hedged equity as part of your portfolio it really allows you to invest more in equities. And so take that 60/40 portfolio, let’s say you wanted to leave the 60 in equities and you wanted to say, “Hey, I don’t really like the low yield environment right now, let’s take the 40%,” right? Let’s take the 40% create a diversified portfolio of hedged equity you’re gonna have, we think, a much better return stream than what you have going forward on that equity. So I think we’ve been used all across the board but I would say predominantly we give clients an ability to add additional equities to their portfolio without a substantial amount of risk. I think that’s really where we’re used mostly.
Meb: What…so you mentioned earlier in the podcast and in the book as well, that this general philosophy can also apply to other markets. So talk a little bit about how you think about this overlay or however you wanna describe it. The DRS as applied to say, international stocks or is it something that can be thoughtful on real assets like REITs and commodities or even bonds or a portfolio as a whole. How do you think about this outside of just U.S. stocks?
Randy: Well, we do apply the DRS to all those different asset classes, so we have four mutual funds for the four equity markets. I mentioned U.S. large cap, small cap, foreign-developed, emerging markets. We also do it on the TLT as well as GLD, so we have some commodities and some bonds in there too. I always go back to it really allows people to get into something like emerging markets where we think a lot of potential exists long-term. But the volatility in the emerging markets is just pretty ridiculous in terms of level of volatility.
So at the end of the day yes, that’s kind of a next step for Swan as we build out our product mix. Is really to be able to give clients the ability to kind of build their own portfolios on a risk managed basis to be able to kind of choose the proportion of different equity markets and different things like gold and stuff like that. And kind of build their own portfolio but say, “Hey, I want this on a hedged basis.” And so we think that the tremendous amounts of backtesting and modelling and stuff like that on all these different asset classes, and it comes back consistently with a similar result.
And so we think at the end of the day this is a much better way to manage this not only just normal market ebbs and flows of business cycles. But obviously, something that we’ve been building to something much bigger, we think, in terms of the debt bubble that’s been building for the last decade or so. That we think is ultimately gonna come to a resolution at some point just not knowing when. And it really allows you to kind of stay in the game without trying to take on too much risk. And I think you alluded to the kind of concepts of Pascal’s wager earlier. And that’s a concept we kind of come back to this whole thing is, we don’t really know exactly how this is gonna unfold. We suspect it’s gonna get painful at some point for most everyone, but you have to take into account all these different market situations into your long-term portfolio.
And if there’s a probability, even if it may be remote that there’s gonna be some massively catastrophic event where the market goes down 60%, 70%, 80%. Then having these types of strategies in your portfolio, we think, is gonna provide a lot of value. And if it doesn’t occur which is obviously also possible, the question is given the low yield environment we’re in right now is, what are reasonable expectations for a portfolio going forward? And I think they’re in the low single digits at this point and I don’t necessarily think it’s gonna be…average exactly 3% or 4% a year. But I’m just saying that with all those different potential outcomes having something that takes into account all the different outcomes, I think makes a lot of sense.
Meb: Fast forward to 2022 the headlines Swan Global launches Defined Risk Strategy on cryptocurrency portfolio, that will be fun to see. Randy, all right, so let’s take a look forward to the future, you got your binoculars, crystal ball. What’s going on in Swan Labs what else you guys thinking about? It could be anything, it can be thinking about portfolio ideas, it could be thinking about anything you’re particularly excited about when it comes to markets, education. What’s on your brain these days otherwise?
Randy: Well, I think the biggest opportunity that Swan has going forward is really the customization aspect of our strategy. So we kind of go back to hey, apply the same strategy from the S&P which has been our historical track record to the different asset classes we’ve already talked about. But really allow clients to come in, bring in their existing portfolios, let us do customization that means create…do correlation analysis for those individual portfolios. Decide, okay this is the way we would create a hedge for that portfolio.
The different risk levels I mentioned, our growth fund, you know, we wanted a growth fund because obviously when you’re in a 10-year bull market some people say that “I want more upside. I want more upside.” Actually, I think our real reason for the growth strategy was not necessarily during the bull market it was for after the bear market. We want people to be able to, if they want more upside after the next bear market they’ll have more upside. So I think it’s the customization in terms of, what types of risk levels, different types of portfolios is really, I think, where we’re at right now. And I think really working with the individual advisor on a consulting basis to help their practice to really kind of grow out.
You know, one of the problems that advisors have nowadays is just the differentiation that they really provide. If everyone is kind of moving towards this kind of robo-advisor type deal where everyone places all the value on the fees which I think are very important obviously. But also coming up with solutions that differentiate themselves between other advisors.
Meb: I think that’s particularly smart on the advisor’s side I mean, I think a lot of people still want to be involved in the actual running of the portfolios. But don’t necessarily wanna be the one that designs the car. So I think that’s a…it’s a pretty thoughtful idea, and the ability to customize it too. Everybody’s got their own spin on things. So being able to add that sort of overlay I think is thoughtful.
Randy, it’s been a blast today where can people find more information on what you guys are up to, what you’re writing about, all your funds, all that good stuff?
Randy: Our website swanglobalinvestments.com. We have a lot of extensive library of blogs and white papers. We do have a tremendous amount of research that’s not just necessarily about our strategy in general, but just the general problems that we have in the markets and solutions and stuff like that. We also do a quarterly kind of investment manager, portfolio managers call. And as you already mentioned the book that’s coming out. So, yeah, just go to our website. We do have lots of…many conferences around the country. I think we’ve already had one in Chicago this year, Houston, and Dallas. I think we’re doing one in L.A. and San Francisco. So, anyone interested in going to some of those types of conferences can reach out to us and we’ll let you know where we’ll be.
Meb: Well, good when you guys are in L.A. certainly reach out and hopefully I can join and listen as well. Randy, thanks so much for taking the time today and tell John and everyone else in Texas hello.
Randy: Sounds good, I will.
Meb: Listeners check out Randy’s book “Investing Redefined A Proven Investment Approach for a Changing World” on Amazon, everywhere else good books are sold. We can find the show notes we’ll post links to Swan Global and a lot of the blogs everything else we talked about today on mebfaber.com/podcast. As well as the archives, over 150 shows. Please leave us reviews. Shoot us an e-mail, let us know what you think firstname.lastname@example.org.
Thanks for listening, friends and good investing.