All of the research Swan conducted prior to implementing the equal-weight approach was based on the idea of Real Estate being a subset of Financials. Real estate is not a large portion of the overall S&P. Giving an equal-weight position to Real Estate based upon GICS’s decision would further increase the relative overweights to small sectors and increase the underweight to the major sectors like Technology and Health Care.
Therefore, the decision was made to act “as if the carve-out never happened.” The relative weights of Real Estate and Financials ex-Real Estate is roughly 20%:80%, or 1:4. Within the 11.11% equal-weight allocation, XLRE and XLF are kept roughly in those proportions. The target weights between the two is periodically updated as their relative weights shift.
Q: How do you rebalance the sectors?
With the mutual fund, rebalancing is easy. There have been considerable cash flows into the fund since inception. With the new money that comes into the fund, we simply allocate to the “hungriest” sector (i.e., the sector that is furthest off target). Once that sector is at its target weight, additional monies are then allocated to the second-furthest off target, and so on. In the case of redemptions, the process is reversed: money would be taken from the most overweighted sector until it is at its target level.
Separately managed accounts utilizing the equal weight sector strategy are a bit trickier. Usually there is much less cash flow in an individual account. If, due to market movements, the sector weights within an individual account move too far from target, Swan will actively sell overweighted positions and reallocate to underweighted sectors. There are pre-defined breakpoints around the target allocations that trigger a rebalance. Obviously, Swan is very cognizant of trading costs and doesn’t want to create excessive turnover in the individual accounts via excessive trading.
Q: Do you hedge with the individual sector ETFs?
No. The DRS hedges with SPX options (i.e., options on the S&P 500 index itself) or SPY options (options on the S&P 500 ETF). These options are among the cheapest, most liquid options in the world. Options on the individual sectors or sector ETFs have only a fraction of the liquidity.
So while it is true that there is a bit of a mismatch, or “basis risk” between an equal-weight sector portfolio and the S&P 500, we believe the deep liquidity of S&P 500 options more than compensates for the basis risk.
Q: Why don’t you equal-weight in IRA accounts?
When it comes to option trading, qualified, tax-sheltered accounts are subject to a stricter set of regulations than regular, taxable accounts, or a co-mingled pool like a mutual fund. According to the regulations, if one trades options in a qualified account, the options must be on an underlying position. Due to the relatively smaller size of IRA accounts and the answer to the previous question regarding hedging sector ETFs, qualified accounts are kept simple. The core, underlying investment is in the S&P 500 ETF (SPY) and the options traded on that position are also SPY options.
It is important to remember that the long exposure to the ETFs is only one part of the overall DRS. The buy-and-hold position in the ETFs is, quite frankly, the “boring” part of the DRS. The other portions of the strategy are the hedge and the premium collection trades. These three complementary portions of the portfolio are designed to work in up markets, down markets, and flat markets, respectively. It is for this reason why some commentators have referred to the DRS as an “all weather strategy.”