By Marc Odo, Swan Global Investments
As many people know, the Swan Global Defined Risk Strategy is composed of three primary elements: the long, buy-and-hold position in an equity market, the hedge on that long position, and the premium collection trades. Most people focus on the hedge and premium components because the DRS’s willingness to tackle market risk via options makes Swan rather unique. But what about the first element to the DRS, the buy-and-hold position in ETFs? Is there anything unique to discuss there?
With our flagship U.S. Large Cap strategy, we are currently roughly equally weighting[1] the various SPDR Sector ETFs. For the first 15 years of the DRS, we did use the SPY/S&P 500 for our market exposure; however, in 2012 we made a switch to this equal-weighted sector approach.
More Money, More Problems
The rationale for equal weighting the sectors has to do with the underlying problems of a capitalization-weighted index. With a cap-weighted index like the S&P 500 or the Russell 1000, the one and only thing that matters is a company’s price. There is no emphasis placed on the valuation of a company, its revenue, its profitability, or any other factor.
The problem with this focus is that the more the price of a stock goes up, the bigger the company gets, and the bigger the company gets, the more of its stock you have to buy in a cap-weighted scheme. This creates a positive feedback loop where the big keep getting bigger; it’s a vicious cycle that may result in a perilous bubble.
The table below highlights the top ten names, by size, in the S&P 500. These ten companies represent almost 20% of the S&P 500. A year ago, it was closer to 18%. Half of these names are in technology:
This trend has been exacerbated by the massive inflows into passive products. The table below shows the top five domestic equity mutual funds and ETFs, in terms of asset flows. The top four are all invested in capitalization-weighted indices. Almost $145 billion has moved into these four over the last 12 months, bringing their aggregate total up to $1.34 trillion invested in just these four index products.
The Bigger the Rise, the Bigger the Fall
This can lead to bubbles in individual stocks or broad sectors. Obviously, the best example of this was the dot-com boom and bust in the late 1990s. We also saw it in financials prior to the subprime crisis. When the correction came in those sectors, it was not pretty. The graph below shows the relative weights in the GICS sectors of the S&P 500 over the last several decades.
Following the bear markets of 2000-02 and 2007-09, technology and finance were reduced to well less than half of their peak weight in the S&P 500. Today, years later, they have yet to fully recover to their peak levels. While it’s anybody’s guess as to how much longer technology’s current run will go on, it is accurate to say that technology’s current weight is greater than it’s been since January 2001.
The Value of Equal Weight
Equally weighting the sectors is a way to reduce the impact the positive feedback loop from the cap-weighted approach. As certain sectors run, the equal weight approach systematically reallocates to undervalued sectors. Such an approach is not making tactical calls on the relative strength or weakness of a given sector. Instead, it is a way of systematically “selling high, buying low.”
Also, equal weighting the sectors is more of a value, long-term investing approach. One way to think about a cap-weighted strategy is as a “momentum” strategy. The stocks or sectors that go up continue to attract assets until the tipping point is hit and the momentum reverses itself. With the equal-weighted sector approach being more of a “value” strategy, it shuns momentum and trends and focuses more on the long-term value of a company.
The aggregate impact on the portfolio is that you have more of a value tilt and less of an emphasis on the megacap names. Sometimes this works, sometimes it doesn’t. In 2015, when the “FANG” stocks delivered almost all of the S&P 500’s returns, the equal-weight strategy lagged. However, in 2016 equal weight was a positive driver to performance, as sectors like energy rallied. In 2017, the equal weight approach has trailed the S&P 500 as growth stocks have run circles around value stocks, again led by “FANG”. Long-term, however, the equal weight strategy still appears to be superior.
The DRS is in It for the Long Haul
Since the DRS is meant to be a long-term investment, the equal weight approach is aligned with our purpose. It has always been Swan’s philosophy that it is worth giving up some of the upside in order to potentially protect more on the downside. Minimizing losses is more important that maximizing gains. Obviously, the hedge is the most direct way we manage downside risk, but the equal weighted sector approach is another defensive aspect of the Defined Risk Strategy.
Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.