SWAN ETF: Hedged Equity Vehicle Looking Appealing

Thesis

Black swan events are rare occurrences, and they usually describe very out of the ordinary transgressions that result in significant market dislocations:

The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The term is based on a Latin expression which presumed that black swans did not exist. The expression was used until around 1697 when Dutch mariners saw them in Australia. After this, the term was reinterpreted to mean an unforeseen and consequential event.

The Amplify BlackSwan Growth & Treasury Core ETF (NYSEARCA:SWAN) is an exchange-traded fund from Amplify that aims to hedge investor returns in cases of sudden and unforeseen market dislocations. We covered this name before, almost two years ago, when we highlighted why the fund’s duration component would be a negative total return driver in a rising rates environment.

With peak rates behind us, the questions swirling in the market are around the timing of the first rate cut, rather than questioning if the next move will be a hike or a cut. In this macro context, we are going to revisit SWAN and ascertain if it is a good fund to own given the phenomenal run in equities in the past year.

Fund composition – long the S&P 500 and treasuries

The fund has a very straightforward build – it contains long-dated S&P 500 options and a ladder of treasury bonds. The S&P 500 options are:

Do not get scared by the nomenclature here, ‘LEAP’ simply stands for Long-Term Equity Anticipation Securities, and refer to options with maturity dates above one year. The fund utilizes this type of option in order to gain long-term exposure to the equity index without the full balance sheet impact of owning the index outright.

The second holding in the ETF is represented by a ladder of treasuries:

The portfolio contains treasury bonds with intermediate maturities of 5-,6- and 7 years. Given its holdings, it is not surprising the fund has a 30-day SEC yield of 3.18%.

In a normalized economic environment, bonds provide a hedge for equities via their negative correlation. In the event of a crisis or unforeseen event, equities lose value while bonds get bid up as a safety valve. We have seen this during the Covid crisis, when stocks experienced a significant drawdown while bonds got a very aggressive bid:

While the S&P 500 experienced a drawdown close to -30%, SWAN had a very modest -5% drawdown, with its performance buffered by the bid caught by bonds. We can see how the iShares 3-7 Year Treasury Bond ETF (IEI) caught a significant bid as Covid developed.

The above graph represents an ideal picture of what SWAN actually does – when outside events occur, the ETF protects investors from very significant drawdowns via its bond sleeve. Outside shocks to the economy are always dealt with via monetary and fiscal stimulus. Thus, the economy gets lower rates and investors get higher bond prices.

Return drivers

The main return drivers for the fund are intermediate rates and equity returns as embedded in the S&P 500. If the S&P 500 return component is fairly straightforward, the bond piece has dragged the fund returns down in the past years.

What we have witnessed in the past two years has been an unprecedented bear market in bonds. With the Fed hiking rates aggressively, bonds in all formats have suffered incredible losses:

Long duration treasuries have suffered the highest losses, with intermediate duration funds down ‘only’ -12% to -16%. As we exit peak rates, we are going to see the opposite occur. When rates move lower, the likes of IEI, AGG and TLT will benefit greatly.

In the outside case of a black swan event, we will see another aggressive bid for treasuries. Think a significant world conflict or any other unforeseen event. While we do not discount black swans, our base case calls for a mild recession which would see the Fed lower rates. Goldman calls for 2 cuts in 2024 and 4 cuts in 2025:

Firstly to note is the higher neutral rate that Goldman assumes going forward, but more importantly a reader should focus on the number of cuts forecasted for the next 12 months. Rate cuts equal higher bond prices, which is beneficial to SWAN even if no outside event materializes. The trend this year has been to push back Fed rate cuts, so in our view we are only going to get one towards the end of the year.

Performance has been robust in 2024

While the iShares Core U.S. Aggregate Bond ETF (AGG) has posted a negative performance in 2024, SWAN is up significantly:

What is interesting to notice is that on a total return basis, SWAN is above the equal weight Invesco S&P 500 Equal Weight ETF (RSP). SWAN has recorded a 6.13% total return this year, versus only 4.72% for RSP. Expect this trend to continue, with large mega-caps benefiting from the rally, while the intermediate portion of the yield curve does not drag down returns, all while providing an embedded hedge.

Conclusion

SWAN is an exchange-traded fund. The vehicle contains S&P 500 LEAP options and an intermediate duration bond sleeve. The fund performed admirably during the Covid black swan event, but was dented by the sudden rise in rates starting with 2022. With peak rates behind us, the fund is again an appealing choice for investors concerned with outside black swan events. In a normalized economic environment the fund will perform, testament being its 6.13% performance in 2024, beating the equal weight full equity RSP fund. As the Fed lowers rates, the bond sleeve in SWAN will deliver positive results, while the LEAP options will follow the wider equity market. We like SWAN’s composition for today’s macro environment and are a ‘Buy’ for the name at the current levels.