SWAN ETF: Investment Thesis Update

Investment Thesis

In my last article on the Amplify BlackSwan Growth & Treasury Core ETF (NYSEARCA:SWAN), I concluded that this strategy was suitable for a risk-averse investor. However, SWAN is down ~14.5% vs ~0.3% for the S&P 500 since early October 2021 and has clearly underperformed the index at a particular moment in time where it should have provided protection. The main reason behind it is related to how bad bonds have performed since Q4 2021. Given the higher-than-expected inflation and the shift in monetary policy, US bonds are now in a bear market. At the moment, it is difficult to predict when inflation is likely to peak, which in my opinion makes bonds unattractive to own. Regarding equities, the probability to have a correction is now much higher than seven months ago. Given the fact that SWAN provides a long-only exposure to equities, I believe the benefits of owning SWAN are limited at the moment.

SWAN’s Performance Since My Last Article

As a reminder, SWAN seeks to prevent significant losses while allowing investors to gain from any increase in the S&P 500 index. This is achieved by investing 10% of the funds in LEAP call options and the remaining amount in U.S. Treasuries of different maturities. Below is a recent breakdown of the portfolio.

I have compared below SWAN’s price performance against the SPDR S&P 500 Trust ETF (SPY), over the last 7 months to assess which one was a better investment. Over that period and excluding dividends, SPY outperformed SWAN by a ~14 percentage points margin which is significant in my opinion.

It is interesting to note that the performance spread started to widen in late December 2021 which coincides with the beginning of a bear market for US bonds. Given the fact that approximately 90% of the portfolio is invested in bonds, SWAN hasn’t been spared by the bloodbath in the credit market.

To put things into perspective, US bonds have been in a bull market for over 30 years and the trend seems to be reversing now on the back of higher than expected inflation. Therefore, yields are climbing fast as the market is adjusting to expected changes in monetary policy. For instance, Nomura sees the Fed hiking interest rates by 75 basis points in June and July in one of the fastest tightening cycles ever. This comes following an expected 50 basis points increase in May. Since the US economy is now in a strong position and unemployment is low, I believe there is nothing preventing the Fed from raising rates going forward.

Market Outlook

As 90% of SWAN’s total assets are fixed-income instruments, I believe it is crucial to understand what are the risks and rewards of this particular asset class. Inflation is a game-changer for fixed income instruments and it is now running at the highest rate over the last 40 years. This came at the moment when central banks were pursuing quantitative easing and a zero interest rate policy, which exacerbated inflation in my opinion. One of the keys to understanding if bonds will continue to underperform is related to the future inflation outcome.

In my opinion, the red-hot pace of inflation is likely to slow down in the coming months, but the timing is extremely uncertain and depends on a number of factors. For the moment, inflation in sectors such as energy and housing isn’t going away yet.

The Global price of Energy index has surpassed the 2008 highs and sits now at a record level, accelerating since February 2022. The Russian invasion of Ukraine makes this topic even more complex as European countries are now actively discussing an embargo on Russian oil. According to some estimates, oil could very well exceed $130 per barrel if the EU moves ahead with this measure. At the same time, China is expected to come out of its COVID-19 lockdown, which reduced its oil consumption in March and April 2022. This can serve as another catalyst to drive the price of energy higher.

Metals are also at a record-high level, despite the Chinese lockdown and real estate bubble bursting. This is another factor contributing to the rise in the PPI in a number of countries throughout the world.

The US housing market is also running hot, which is in my opinion an excellent indicator of inflation given the fact that real estate and rents constitute a large proportion of household spending. That said, I personally think this market is likely to cool off in the next months as average 30Y mortgage rates already exceed 5%, and still have room to rise higher.

If we look at agricultural commodities, food prices are higher compared to March and January 2022. For the time being, I don’t see any change in the prevailing trend which could signal a slowdown in food inflation.

All in all, 2022 is the year where both US bonds and equities have delivered disappointing returns simultaneously. While US bonds were considered a safe haven type of asset until recently, I believe inflation changed the rules of the game. Therefore, the future performance of fixed income instruments will depend on future inflation and the monetary policy response to it. Given the uncertainty surrounding future inflation at the moment, I don’t think bonds are providing an effective hedge against a stock market downturn.

Turning now to the equity component of the strategy, I think it is interesting to note that implied volatility is now higher than pre-COVID-19 and it will likely remain elevated in the coming months. Implied volatility (IV) has a direct impact on the price of the option. In other words, an increase in IV should lead to an increase in the premium paid. This can be seen as detrimental for option buyers.

Lastly, inflation is likely to do more damage than it is expected to valuations across the board. Inflation has historically been negatively correlated to PE ratios. In other words, when the CPI is hot, PE multiples tend to suffer and vice versa. This comes at a time when the S&P 500 trades at over 33x cyclically adjusted earnings, thus increasing the risk of a severe downturn in US equities.

Key Takeaways

Fixed-income assets constitute a large share of SWAN’s portfolio. Given uncertainties surrounding future inflation and monetary policy, I believe owning bonds today is unappealing from a risk-reward perspective. Furthermore, the likelihood of an equity market crash is now considerably higher than it was 7 months ago. As a result, a long-only exposure is not the most appropriate strategy going forward. I would personally favor a long-short portfolio composed of both SPY puts and calls.