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Tristan YatesTristan Yates and Lye Kok (IndexRoll) submit: Here’s a recap of 40 years of discussion and analysis of Index investing:

  1. Indexed Investing is the only equity investment strategy with decades of performance-related statistics available. Since 1927, the Index has a CAGR of +10.27% over an 80-year history.
  2. Popularized by John Bogle and based upon academic work by Eugene Fama, Indexing was originally derided as “un-American” because the perception was that investors should settle for average rather than exceptional performance.
  3. However, Indexing offers superior and more consistent returns than most actively managed funds. For example, Bogle’s Vangard S&P 500 fund has beaten the performance of over 90% of other mutual funds over the last ten years.
    Most of the superior performance of Index tracking funds is due to stock selection, but lower turnover costs and management expenses are also factors.
  4. Later work by Fama & French led to the creation of other indexes weighted by market cap and book value. Investors now usually hold multiple indexes to improve diversification. For example, small-cap value stocks have returned +13.3% annually over 80 years but have higher volatility.

Indexing is firmly established in the investing marketplace. Over $1 trillion is currently indexed, and there are estimates that one-third of all new money flowing into common-stock money market funds is invested in some type of index fund.

Should We Lever The Index?

Given the virtues of Index funds, if you have the opportunity to borrow cheaply to invest in an index fund, should you? James Tobin, a Nobel-prize winning economist, addressed that question almost 50 years ago.

Tobin recognized that the optimal portfolio for any investor is the market portfolio (i.e. the Index) plus some level of cash or debt. A short-term investor with more immediate liquidity needs would keep more of his or her portfolio in cash, while a long-term investor would be “short cash”, or would hold debt, in order to purchase a larger investment portfolio and thereby receive more money in the future.

In practice, holding investment debt is problematic. Margin capacity is limited and the high interest rates on margin debt sharply reduce the available returns. And of course there’s the possible risk of a deep market correction and subsequent margin call.

Rolled LEAPs as Investment Debt

There is an alternative for investment debt that’s cheaper, more stable, and provides higher leverage. Since 1990, LEAPs, have been available on a number of securities including Index-tracker ETFs such as the SPY, MDY, and EFA.

Like all options, LEAPs are priced using the Black-Scholes model, and because Index ETFs have very low volatility as compared to most stocks, the option premium is very low at lower strike prices (i.e. deep in-the-money). This results in LEAPs being a very low-cost source of investment debt for portfolios with Index ETFs.

LEAPs expire, but they can always be replaced by a LEAP at the same strike price with a later expiration. For example, a two-year LEAP could be held for a single year, and then sold and replaced with another two-year LEAP. This can be done indefinitely.

Replacing LEAPs in this manner is called an “option roll forward” or sometimes just “the roll”. Rolling forward is inexpensive because the investor only has to pay the price difference between the two options.

Future roll forward costs will typically decline as the price of the underlying Index ETF appreciates. However, the exact costs will be dependent upon a number of factors, including volatility, forecasted dividends, and changes in interest rates, and can never be exactly predicted.

Example Index Option

SPY is trading at $145.30 today, and if SPY continues its historical appreciation, in five years it should be trading at $234.

A two-year option on SPY with a strike price of $110 is trading at $41.60. Rolling that option over for three additional years will cost $3.50 per year. This is estimated by using the difference between the one-year and two year option at the same strike price as a proxy.

After five years, we’ve paid $52.10 in purchase and rollover costs per share, and our option is now worth $124. This is a 20% annualized return over five years, when the timing of the roll forward payments is taken into account.

The high returns are possible because the LEAP option allows us to borrow at approximately 3%. The annual return is actually higher in the earlier years because more leverage is involved – the option builds equity and loses leverage over time.

Risks

The greatest risk is that an investor overestimates their ability to manage a large, leveraged portfolio, either financially or psychologically. If the investor can’t or won’t continue to roll their options forward, a poorly timed expiry could leave them with little or no intrinsic value, wiping out years of investing. Rolling their option up to a higher strike price and then forward would always be preferable to letting the option expire.

There is also the risk that adverse market conditions create a situation where purchasing additional time is more expensive. This could happen during a market correction and/or a period of increased volatility. However, because the investor is only paying the difference between the one-year and two-year options, the effect would be muted and shouldn’t significantly change the long-term investment results.

In summary...

Indexing is the only equity investment strategy that is backed up by 80+ years of historical data and academic research. The availability of Index ETFs and LEAPs allows investors to build long-term investment portfolios that combine the benefits of both indexing and cheap leverage, but without the risks of margin calls.

The underlying portfolio continues to compound and appreciate while the investor makes the ongoing roll-forward payments. At purchase, the leverage, volatility, and expected returns of the option are high, but these variables decline over time as the option builds equity. 18-20% annual returns are achievable given sufficient time and initial leverage.

Leveraged index-tracking portfolios should expect to experience high initial volatility, and it’s critical that the investor commits to rolling forward their Index ETF options, regardless of future market or financial conditions. The Index Roll is only appropriate for an investor with a long-term investing horizon.

Full disclosure: long OEF, MDY, EFA, XLF, XLV, and IWN at time of writing.

Source: Indexing On Steroids