A Better Alternative To Cash: Risk-Free Income Yield Of 3%-Plus

|
 |  Includes: GOOG, IBKR, TD
by: Stanford Chemist

Summary

With the major U.S. indices at all-time highs, raising cash may be a prudent decision as one waits for better opportunities.

However, parking cash in "risk-free" CDs or T-bills yields next to nothing thanks to the Fed's zero interest-rate policy.

A risk-free strategy is presented that could be conceivably used as a substitute for a large cash position in a portfolio.

Introduction

Bulls point to the improving global economy, the lack of market euphoria and the Fed's accommodative monetary policy as factors that will continue to drive this bull market higher. But with major U.S. indices at all-time highs and not having had a significant (10%) correction in the past few years, many other investors are wondering whether now is the right time to put more money in the market, or whether they should be raising cash instead.

While market timing is a fool's errand, valuation measures (arguably one of the best predictors of future returns) point to future returns being more modest. For example, the current P/E ratio (19.4) of the market is now higher compared to the historical mean (15.5). Additionally, the current Shiller P/E ratio (26.2), which adjusts for earnings, is very high compared to the historical mean (16.5). Clearly, with no "blood on the streets", stocks are no longer a table-banging buy compared to only a few short years ago.

Without going fully "all in" or "all out," what are the possible options for the conservative investor going forward?

  • Buy high-quality, "safe" stocks that will withstand the next market correction. Look for mature, dividend-paying stocks that increase their payouts every year. The dividends and income section on SA contains many resident experts on the dividend-growth investing strategy.
  • Hedge your portfolio using options. Writing covered calls can enhance income at the opportunity cost of foregoing future gains, while buying puts can protect the value of your portfolio, at a cost. SA contributors Jeff Miller and Fear & Greed Trader are two of the experts I follow that emphasize the covered call approach.
  • Reducing equity positions by selling shares. This might be the simplest strategy to implement for the conservative investor. The rest of the article will be devoted to what one might do with the cash proceeds from the sales.

The Role of Cash in a Portfolio

The role of cash in a portfolio is a hotly debated topic, and views on this issue are diverse. Respected SA authors Chuck Carnevale ("Why It's A Mistake To Hold Cash In This Market") and Adam Aloisi ("Why Holding Cash May Not Be A Bad Idea In Today's Market") penned contrasting pieces discussing this issue a few months ago, and the articles and comment streams make for lively reading. Meanwhile, the financial author and investment advisor Larry Swedroe has generally recommended a mix of value equity funds and high-quality bonds (no cash), while the late Harry Browne advocated a 25% allocation to cash in his "permanent portfolio". At the other extreme, not a few SA commenters have stated that they have moved completely to cash in fear of the impending correction (or crash). Personally, I like to keep a 10% cash position that allows me to take advantage of good opportunities without needing to liquidate existing positions.

What cannot be debated, however, is that the yield of cash has dropped drastically over the past few decades. The global financial crisis of 2007-2008 forced the Federal Reserve to undertake drastic actions to save the U.S. economy. One such action was to implement the "zero interest-rate policy," which was targeted towards encouraging spending and lending by consumers and banks. Unfortunately, this system unfairly punishes savers, who have seen deposit rates plummet to all-time lows.

This environment has greatly increased the popularity of income stocks, including dividend growth stocks, REITs, MLPs, BDCs, royalty trusts, to name but a few. Additionally, bond investors have been forced to take on more credit risk (junk bonds) or interest-rate risk (long-dated bonds) to satisfy their income demands. However, the aforementioned securities all come with risks (of capital loss), and cannot be used, vis-a-vis, as a substitute for a cash.

With "risk-free" (shorted-dated) CDs and treasury bills yielding near zero, what might a conservative investor do with the large cash position he has in his portfolio? This article describes a strategy that can be used to generate 3%+ annual yield that preserves the characteristics of cash (liquidity and minimal risk to capital). This technique utilises contracts for difference (CFDs).

Contracts for Difference

CFDs are financial derivatives that allow investors or traders to make bets on financial instruments, without having to own the underlying security. From Investopedia:

An arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than the delivery of physical goods or securities.

This is generally an easier method of settlement because losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.

Many traditional brokers offer CFD services, including Interactive Brokers (NASDAQ:IBKR) and TD Direct Investing International (NYSE:TD), while many others specialize in CFD-trading only, such as Plus500 (PLUS:LN) and ETX Capital (country restrictions may apply).

A major advantage of CFDs is leverage. Stocks can be bought at 1:50 (or even more) of initial margin, meaning that you only have to pay 1/20 (or even less) of the price to control the same amount of stock as in a normal brokerage account. However, leverage is a double-edged sword. If your capital falls below the minimum maintenance requirement, you will receive a margin call and your position will be automatically liquidated. Furthermore, one must psychologically guard against taking undue risks because the low initial margin requirement might lead you to think that less of your capital is at stake compared to the true situation.

Additionally, certain brokers charge or offer a premium to hold a position overnight. You might receive interest for holding a short position in an underlying security overnight, while being charged interest for holding a long position.

Finally, one should be aware of the drawbacks of trading with CFDs. Only the more liquid stocks, ETFs, indexes or commodities are usually available for trading. Furthermore, bid-ask spreads may be higher than trading on the normal stock exchange. Finally, there is generally less regulation with CFDs compared to a traditional stock exchange. Due diligence is required to understand how each broker protects your money.

Yielding 3%-Plus Risk-Free

This is a truly risk-free strategy, which means that under normal circumstances you will not lose any capital at any time. The technique is actually rather simple. You simply short the CFD on your CFD broker, and buy the underlying stock with your normal broker.

For example, one could short 100 share's worth of Google (NASDAQ:GOOG) (NASDAQ:GOOGL) using CFDs and buy 100 shares of GOOG in your normal account. At the time of writing, GOOG was trading at $560.55, so you'd be controlling $56,055 worth of GOOG on either side of the trade. Since GOOG can be bought on 1:50 margin with CFDs, you'd only have to put down $1,121.1 for the short side of the trade, so your initial capital invested is $57,176.1.

The reason that this strategy works is because my CFD broker pays me 0.01% interest daily on holding a short position of GOOG, which works out to be 3.65% interest per year. To repeat, you are being paid to short a stock (note that only certain brokers offer this). If the price of GOOG does not change at all in a year, you will gain $56,055 * 3.65% = $2,046 cash in your CFD account. Given that you invested $57,176.1 up-front, this works out to be a 3.6% annual gain.

However, this value will be reduced slightly because of the bid/ask spread on both the stock and the CFD, so you'd be down a small amount from the get-go. The spread on the CFD for GOOG with my CFD broker is 55c (0.10%), corresponding to an up-front $55 cost, while the spread on the Nasdaq as shown by my normal broker is 24c (0.04%), corresponding to a $24 cost. There's also the issue of commissions for a regular brokerage account, which we'll assume to be a flat cost of $10. Obviously, the shorter the time you hold the trade, the larger the friction cost becomes as a proportion of your total profit. Using the one-year time frame above as an example, your total profit would then be reduced to $2,046 - $89 = $1,957. This reduces your annual gain to 3.4%.

Now what would happen if the price of GOOG fell by $100 over a year? Because you are fully hedged, nothing would happen. Your would lose $10,000 in your normal brokerage account ($100 x 100), and gain $10,000 in your CFD account. Note that since the interest paid to you is calculated as a percentage of the current value of the security, the premium may also be reduced accordingly. Assuming the price fell uniformly, your profit would be $1,864 after one year. After taking into account the friction cost of $89, your annual gain would be 3.1%.

What if the price of GOOG rose by $100 over a year? This is a bit more tricky because you would have to deposit an extra $10,000 in your CFD account to prevent a margin call. You would now make more profit because your premium interest would increase accordingly ($2,229 after one year assuming a uniform price rise), but your capital invested would be higher ($57,176.1 + $10,000 = $67,176.1). After taking into account the friction cost and the higher capital investment, your annual gain would be 3.2%.

Importantly, the fully-hedged nature of this strategy means that you can close the trade at any time and without loss (excluding friction costs). This technique therefore maintains the favorable characteristics of cash: liquidity and minimal risk. Rebalancing is not required, but you may have to periodically deposit cash into your CFD account if the value of the stock rises. If the value of the stock rises too quickly, you can simply close both sides of the trade and re-open with the initial capital invested.

Conclusion

While 3% isn't much, it is still a lot more than what you'd be currently getting from a "risk-free" short-term CD or treasury bill. Therefore, this strategy could conceivably be employed as a proxy for a large cash position in a portfolio. Importantly, this strategy is fully-hedged meaning that you can close the trade at any time without losing any capital, and rebalancing is not required. Though not groundbreaking by any means, hopefully this simple strategy could stimulate further discussion on "risk-free" arbitrage strategies by the astute readers of Seeking Alpha, as well as provide an introduction to CFDs for readers who have not encountered this type of instrument before.

Addendum: In the comment stream, I was drawn to the very important point that since CFDs are derivatives, you are subjected to counterparty risk of the CFD broker and/or another counterparty. Therefore, as mentioned in the article, due diligence is required to understand how each broker protects your money. Hence, this strategy should not be considered completely risk-free.

Disclosure: The author is long GOOG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a client of Plus500 and ETX Capital but I have no other business relationship with them. I have not been solicited by them to write this article and I receive no material or immaterial compensation from them from writing this article.