SWAN - SWAN: Now Is A Good Time To Own

2023-04-18 06:17:16 ET

Summary

• SWAN has been a massive loser over the past 18 months, but I believe that now is a good time to hold shares.
• The ETF delivered pitiful returns in 2021-2022 because of its unhedged exposure to treasuries. The risk still exists in the current year.
• However, I think that yields have climbed enough to offer investors a compelling buy-the-dip opportunity in SWAN.

The Amplify BlackSwan Growth & Treasury Core ETF ( SWAN ) has been a massive loser over the past 18 months. Shares have been down 25% since late 2021, including the effect of cash distributions to investors, compared to the S&P 500's ( SP500 ) much tamer drawdown of only 12% (see below). Such performance can be disappointing for an ETF designed to help protect shareholders against black swan events.

That said, I believe that now is a good time to hold shares of SWAN. Below, I explain why the move makes sense to me in both the short and long terms (say, 12 months and several years, respectively).

Understanding SWAN

While I have explained how SWAN allocates its capital in previous articles, the strategy is unique enough that it deserves a recap.

The fund invests in US stocks and government bonds but in a novel way. The exposure to the S&P 500 is achieved through long positions in index call options. The remainder of the capital is allocated to treasuries that mature as early as next year and as late as 2052, for a weighted average maturity period of 11.5 years as of the writing of this article. A small amount is parked in cash, probably for quarterly distribution purposes. See the pie charts below.

By investing in the S&P 500 through in-the-money calls, which requires less capital than investing in the index through a plain ETF, SWAN is able to leverage its exposure to the stocks-and-bonds combo. This is why the nominal capital allocation (left chart above) adds up to 100%, but the notional allocation (left chart above) is nearly 160%.

The ETF's goal is straightforward: (1) to grow its assets fairly aggressively, considering the leverage factor, while (2) protecting the stock piece of the portfolio against sizable losses, since the fund can only lose as much as it has invested in the call options (i.e., the premium paid).

A true black SWAN event

Despite the ugly returns displayed earlier, SWAN has performed in line with its strategy. The ETF's equity-related losses were capped as the S&P 500 took a dive in 2022. The problem is that US government bonds had their worst year of performance since the Great Depression of the 1920s and 1930s at least, as inflation worries lingered and interest rates increased at a dizzying pace.

This toxic combination of high consumer prices leading to sharply higher interest rates and lack of confidence in economic growth caused an unusual one-two punch: sharply lower stocks and bonds. According to data from NYU Professor Damodaran that goes back to 1928, the S&P 500 and long-term treasuries had never returned less than -15% for the year at the same time until they did so in 2022. In fact, both asset classes had not returned less than -10% in the same year in more than nine decades.

SWAN was never designed to protect investors against a sizable pullback in bonds and stocks at the same time - a true black swan event. This is something that I highlighted in my May 2021 article , months before the bond market took a massive turn for the worse.

SWAN does not offer any protection against bear markets anywhere else but in large-cap US stocks. The ETF will remain exposed to large losses in bonds, which can be painful in the current environment of rising yields and expectations for higher inflation - the Achilles' heel of the black swan strategy .

Why I like SWAN today

To be fair, nothing that happened in 2022 changed the structure of the SWAN portfolio. The ETF remains fully exposed to a slide in bond prices, even if protected from a sizable pullback in stocks.

In order to minimize losses on both the equity and the bond sides of the portfolio, one would probably need to manually construct a portfolio of options. Such an approach, however, could be costly and much more complex.

But I believe that the risks of owning SWAN now are lower than they were in late 2021 and early 2022. Government bond yields have already spiked past 4% or 5%, depending on the maturity, to reflect the rising inflation environment. If anything, talks of a potential interest rate cut in the summer have already surfaced, while fears of an incoming recession seem to have helped to push yields much lower in the past few weeks.

Between stocks and bonds, I am currently more concerned (although not overly so) about a potential pullback in the S&P 500. As I argued recently , "a recession has not been this obviously telegraphed in many decades", and I am not confident at all that stock prices fully reflect the risk of economic deceleration this year and/or next. But at least, when it comes to SWAN, the risk of a potentially sizable correction in stock prices is well mitigated by the options position.

Last few words

To be clear, SWAN remains a fairly risky ETF ( maximum drawdown since inception has been sharper than the S&P 500's, using month-end price points) that is probably best suited for growth investors with a long-term horizon in mind. Also, I continue to see the same flaws in the strategy that I identified about two years ago, namely (1) the lack of loss protection for the bond position and (2) no exposure to assets that could thrive in an inflationary environment, like gold and TIPS.

That said, I think that the diversified multi-asset class strategy still has its merits. Better yet, buying shares that are currently 25% below peak levels and down about 2% per year since the start of the COVID-19 crisis will likely prove to be a smart buy-the-dip move in the end.

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