SWAN - SWAN: Duration Risk Not Well Advertised

2023-07-12 02:04:48 ET

Summary

• The article provides an overview of the BlackSwan ETF.
• The SWAN ETF aims to protect against 'black swan' events by owning treasuries and long-dated options on stocks.
• While it reduces equity risk, the SWAN ETF also introduced large duration risk that was not properly measured and communicated to investors.
• I recommend investors remain vigilant about overly engineered products like the SWAN ETF and stick with portfolio diversification to protect against unknown risks.

This article examines the Amplify BlackSwan Growth & Treasury Core ETF ( SWAN ), a fund marketed as providing upside exposure to stocks while protecting downside from significant losses.

While the SWAN ETF is able to reduce equity risk with the use of options, it introduces massive duration risk from a portfolio of treasury bonds that is not properly communicated to investors. When stocks and bonds fell in tandem in 2022, investors were left with a large underperformance relative to the markets.

Overall, I would avoid overly engineered financial products and stick with diversification to reduce risk from 'black swan' events.

Fund Overview

The BlackSwan ETF seeks to provide uncapped exposure to the S&P 500 while providing downside protection from significant losses. The SWAN ETF achieves the target result by investing most of its assets in U.S. treasury securities and obtaining equity exposure via options on the SPDR S&P 500 ETF Trust ( SPY ).

The SWAN ETF has $220 million in assets and charges a 0.49% expense ratio.

Strategy

The SWAN ETF tracks the S-Network BlackSwan Core Index ("Index"), a rules-based quantitative index that seeks to provide capital protection against 'black swan' events (Figure 1). The Index seeks to provide some participation in the S&P 500 Index by allocating approximately 10% of the index market capitalization to a portfolio of in-the-money ("ITM") LEAP options on the SPY ETF. The other 90% of the index is allocated to a portfolio of U.S. treasury securities.

According to the manager's estimates, the purchase of the LEAP options allow the index to participate in approximately 70% of the upside of the SPY ETF over a cycle. At the time of purchase, the LEAP options chosen will be in-the-money and have a delta of 70 (for every 1% change in the underlying, the option value will change by 0.7%) with expirations of at least 1 year, expiring either in June or December.

The U.S. treasuries portfolio is used to protect capital against 'black swan' events. When the SPY ETF suffer losses, the LEAP options are expected to participate in approximately 70% of such losses; but the U.S. treasury portfolio is expected to mitigate overall losses.

The index rebalances every June and December to coincide with the option expiries.

Portfolio Holdings

Figure 2 shows the holdings of the SWAN ETF as of July 10, 2023. The SWAN ETF essentially holds a treasury bond ladder with maturities between 2028 and 2033. The SWAN ETF also holds LEAP options on SPY with December 2023 and June 2024 expiries at 380 and 400 strikes respectively.

Distribution & Yield

The SWAN ETF pays a quarterly distribution that annualizes to a 3.0% yield (Figure 3). SWAN's distribution is funded by its treasuries portfolio.

Returns

Figure 4 shows the historical returns of the SWAN ETF. The SWAN ETF had performed well from 2019 to 2021, with returns of 22.3%, 16.6%, and 10.3% respectively and generally performing as designed. However, 2022 was an especially bad year, as the SWAN ETF returned -27.4%. YTD 2023, the SWAN ETF has returned 6.6% to June 30, 2023.

Figure 5 shows the historical returns of the SPY ETF for comparison. Although marketed as protecting downside, the SWAN ETF failed its mandate in 2022, returning -27.4%, far below the SPY ETF's -18.1%.

What happened in 2022 that caused the SWAN ETF to underperform so dramatically versus its design?

SWAN's main headwind in 2022 was due to the Federal Reserve's interest rate increases to combat soaring inflation. Although the Federal Reserve targeted short-term interest rates, the rise in short-term interest rates also pressured interest rates higher across the yield curve. Altogether, the Federal Reserve increased short-term interest rates by 500 bps since it began the current rate hike cycle March 2022.

When interest rate rise, bonds lose value due to duration . In simple language, the treasury bonds that the SWAN ETF held in its portfolio have varying contractual cash flows far in the future. When interest rate rose, the discount rate used to calculate the present value of those cash flows increased, causing those bonds to lose 'value'.

What I find interesting is that nowhere on Amplify's website is the duration risk of the SWAN ETF's portfolio mentioned. In fact, Amplify does not provide the weighted average duration of the SWAN ETF's portfolio, despite 90% of the fund being invested in long duration treasury bonds.

Fallacy Of Relying On Historical Correlation

The failings of the SWAN ETF comes down to the fallacy of relying on the historical negative correlation between treasuries and the S&P 500 Index to protect the portfolio (Figure 6). The 'black swan' SWAN fund was not properly prepared for a 'grey swan' (predictable but unlikely) event of bonds and stocks declining at the same time.

The problem is that a negative correlation between bonds and stocks is a relatively recent phenomenon. If we stretch the chart back further, we can see that prior to the 2000s, there were long periods when stocks and bonds were positively correlated, according to data from the Investment & Pensions Europe (Figure 7).

So only using correlation data from the past 20 years to design a 'black swan' product to protect against the unknowable is almost destined to fail at some point.

SWAN Not Alone In Its Misery

In fact, the SWAN ETF was not alone in its misery. Many other strategies 'designed' to protect against tail risks also failed miserably in 2022. For example, the Cambria Tail Risk ETF ( TAIL ) that owns out-of-the-money ("OTC") options on the S&P 500 Index declined 13.2% in 2022, offering no protection against the equity bear market (Figure 8). I wrote about the TAIL ETF's misgivings here .

Similar products like the Simplify Tail Risk Strategy ETF ( CYA ) did even worse, losing 45.4% in 2022, almost triple the loss of the SPY ETF (Figure 8).

Conclusion

Using historical data from the past 20 years, the SWAN ETF's design made sense as treasuries and stocks were negatively correlated so when stocks fall, bonds would rise and protect the portfolio. Unfortunately, the 'black swan' SWAN ETF that was supposed to protect against unforeseen risks failed to protect against a 'grey swan' event of stocks and bonds falling at the same time.

This is yet another example of financial engineering looking good on paper but failing in practice. In my opinion, investors need to be vigilant about the hidden risks with their investments. Always ask hard questions and due your own diligence.

At the end of the day, a black swan event like the COVID pandemic is impossible to predict so the best solution may be to reduce leverage (if any) and focus on diversification, instead of relying on financial engineered products that may give a false sense of security.

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