Saturday, February 2, 2008

Outperform S&P500 with S&P500 futures, Part 2

It is a well known fact that over time the stock market is in a long-term secular bull market. We do get potential hiccups like the Asian financial crisis in 1997-1998, as well as some major bear markets like the one after the 1929 crash, the1973-74 bear market and the 2000-2002 burst of the internet bubble. Since the stock market always seems to recover from any declines over any period of time, I believe that a long-only approach for holding a basket of stocks like the S&P 500 would be a profitable strategy in the long run. In my previous article (Outperform S&P500 with S&P500 futures, Part 1) we learned that an investor can participate in the upside or downside movements of the index with only a controlling stake ( the margin requirement) of 10% of the value of S&P 500 e-mini futures contract. So what could the result be if we try to enhance our S&P 500 exposure through investing in stock index futures? It is possible to achieve the 1.25, 1.5 or even 2 times the annual percentage return of the S&P 500 index through buying more contracts covering a higher dollar amount of S&P 500 companies. This strategy would be profitable in the long run only if done with at least several million dollars in order to correctly enhance the annual portfolio return. So lets say that we start with $10,000,000 and for simplicity sake the S&P 500 is trading at 1,000 at year end which means that every e-mini futures contract is valued at $50,000. We would like to achieve a 1.25 times the return of the index. Thus, instead of buying 200 e-mini contracts, we would buy 250. We would have to roll-over each quarter the futures contracts that we have and try to maintain their number unchanged over the course of the year. Let’s say that at the end of the year the S&P 500 is trading at 1,100, which is a 10% annual return. Our contract is valued at 55,000 now. But since we have 250 contracts, our annual gain is 12.5%. If however the index fell by 10% we would lose 12.5%. We need to rebalance our portfolio every year however, in order to accurately try to achieve a 1.25 times the performance of the underlying. Assuming that we had a gain in year 1 of 10% the value of our enhanced portfolio would be $11,250,000. This could allow us to buy 204.55 contracts at the current value of $55,000. In order to achieve a 1.25 times the enhanced return in year 2, we need to own 255.68 contracts. Unfortunately though, one cannot buy fractions of futures contracts. We could however substitute the fractions with ETF’s covering the S&P 500 index. .68 contracts @ $55,000 equal $37,400. We could simply buy around 340 shares of SPY, which normally trades at around 10% of the value of the S&P 500 index.

This strategy works very well during bull markets, since it compounds your gains significantly. During bear markets though, an investor using the enhanced approach would suffer higher losses than those who invest using the non-enhanced approach. It would take investors much more time to recover from the enhanced losses and thus the strategy would have to deliver very high results in order to recover to the breakeven level. If you refer to figure 2, you will see that a 10% loss only requires an 11% gain to recover. However, once you lose over 50%, you need to achieve enormous gains JUST to break even.
Thus, I would not enhance my exposure to S&P 500 through futures by more than 1.25 times. If your exposure is 2 times, then you will be wiped out if the index falls by 50% in a given calendar year. In order for me to be wiped out with a 1.25 times exposure, the index would have to fall by 80% in a calendar year.

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