This article first appeared in the October 2011 issue of Registered Rep. magazine
There's always been a difference between the futures and securities markets, for better or worse, according to many money managers. Futures, as risk transference vehicles, rely upon leverage to make hedging practical for the market's commercial users. In the futures market, everything is margined while cash trades are the norm for stock transactions.
Leverage in the commodities market is extended further for spread trades — combinations of related futures that exploit variances in the price relationship between the contract legs. An increase in the relative value of gold, for example, can be exploited by purchasing gold futures while simultaneously selling silver contracts short. As long as the trade is done in the contract ratio delineated by the exchange clearinghouse, the long and short positions will be margined as a unit and at lower rates than outright gold or silver futures. Commissions and transactions charges are also reduced, making spread trades very cost efficient.
Portfolio managers and institutional traders used to grouse about the higher capital requirements of spread trading on the securities side. Even some retail advisors have voiced frustration with securities' clunkiness, though complaints were noticeably louder before the introduction of leveraged exchange-traded products.
Consider the manager who thinks stocks are likely to underperform gold. At one point, his only securities option might have been purchasing shares of the SPDR Gold Shares Trust (GLD) while selling short SPDR Depository Receipts (SPY). He'd be required to put up Reg. T margin (50 percent) to obtain any leverage, so each leg's value could thus be ratcheted up to two times his available cash. This wouldn't have been permissible for certain fiduciary and retirement accounts such as IRAs and 401(k)/403(b) plans, however. They're precluded from margin trades. For permissible transactions, two commissions would be due on the trades, interest would have to be paid on the loan financing the long side, and any dividends earned during the spread's pendency would ultimately be owed to the ETF lender on the short side.
Now, however, leverage can be easily obtained by using newer-generation products. For example, the ProShares UltraShort S&P 500 (SDS) offers 2x-levered and inverse exposure to the S&P 500 index while the ProShares Ultra Gold (UGL) aims to deliver two times bullion's daily returns.
These ETFs neatly solve the manager's leverage problem since they can both be acquired in a cash account, but they'd still require two commission round trips. Those ProShares aren't cheap, either. Each fund carries a 95 basis point (0.95 percent) annual expense — considerably more than the 40 basis point cost for GLD and the even-cheaper 9-basis-point charge for the SPY portfolio.
Enter FactorShares, a line of products advertised as “the first family of spread ETFs,” that puts long gold and short stocks — among other exposures paired against the S&P 500 — into a single levered portfolio. A single portfolio means only one commission is paid. To boot, a relatively modest expense ratio of 75 basis points is levied for the coupled trades. In short, each FactorShares portfolio tracks the differences between two futures components, one of which is always the S&P 500 E-Mini contract. FactorShares funds target a daily return equivalent to +200 percent and -200 percent of that earned by the embodied long and short futures contracts, respectively.
FactorShares thus allow investors to trade the relative value of two dollar-neutral futures positions for modest expense and a single commission, all within a cash account.
A Suite of Products
So, what exposures can be obtained through FactorShares? At present, there are five funds in the suite:
FactorShares 2X: Gold Bull/S&P500 Bear (FSG)
FSG is designed for investors who believe gold will increase in value relative to large-cap U.S. equities in one day or less. The fund sells S&P 500 E-Mini contracts short against the purchase of Comex gold futures and, like all FactorShares portfolios, rebalances near the end of each trading session to its daily -200 percent/+200 percent targets.
FSG, not surprisingly, has been the most active FactorShares portfolio, trading an average of 53,579 shares daily since the suite's February launch. The fund, however, isn't “sticky.” FSG's assets totaled just $6.3 million in August.
You can plainly see leverage at work in the FSG portfolio. The fund's standard deviation is about four times that of gold, proxied by the SPDR Gold Shares Trust, and the S&P 500 index mirrored by SPDR Depository Receipts. In real world terms the maximum daily value excursions (both losses and gains) are also about four times that of the underlying exposures.
FSG's goosed-up volatility, in fact, costs the fund some alpha compared to an outright position in unlevered gold. You can see that reflected in the fund's Sharpe ratio, a measure of risk-adjusted return.
FactorShares 2X: Oil Bull/S&P500 Bear (FOL)
Investors expecting oil to outperform blue chip equities in the near term will be attracted to FactorShares' second most active portfolio. FOL takes long positions in Nymex West Texas Intermediate crude oil contracts while selling S&P 500 E-Minis short. From inception, FOL has averaged a daily turnover of 35,616 shares and has built an asset base of $4.3 million.
This year's weakness in domestic crude oil prices has weighed heavily on FOL's long WTI exposure. Compared to the United States 12-Month Oil Fund (USL) — a contango-suppressing oil product (more about contango later) — the FactorShares portfolio's volatility was actually dampened by the S&P position. Oil prices have gyrated more wildly than stock values in 2011.
FactorShares 2X: S&P500 Bull/USD Bear (FSU)
FSU caters to investors expecting weakness in the U.S. dollar relative to the domestic stock market. The fund holds long positions in S&P E-Minis versus short positions in U.S. Dollar Index futures. With $5.3 million in assets, FSU's daily volume averages 4,280 shares.
Here, the FactorShares' short dollar exposure is compared to the PowerShares DB U.S. Dollar Index Bearish ETF (UDN) which tracks, without leverage, short USDX futures. The underlying contract weights the greenback against the euro, the yen, sterling, the Canadian dollar, the Swedish krona and the Swiss franc.
Compounding the S&P 500 index losses in 2011 swamped the modest gains earned by the short dollar exposure.
FactorShares 2X: TBond Bull/S&P500 Bear (FSA)
Finally, FactorShares offers a pair of opposing portfolios pitting long-term Treasury bonds against the S&P 500 index. The FSA fund, holding long Treasury bond futures and short S&P 500 E-Mini contracts, is designed for investors who believe the equity risk premium will contract in the immediate future. FSA is sized at $2.8 million and trades an average of 3,881 shares daily.
FSA is one of two FactorShares portfolios that have accrued long-term — well, since inception, anyway — gains. U.S. Treasury bonds, along with gold (the other FactorShares winner is the FSG Long Gold/Short S&P fund) have become the safe haven investments this year.
Like the FSG portfolio, volatility cost the FSA fund alpha compared to the total return of the iShares Barclays Capital 20+ Year Treasury Bond ETF (TLT), an unlevered fund.
FactorShares 2X: S&P Bull/TBond Bear (FSE)
A bet on expansion in the equity risk premium is manifested by the FSE portfolio's short Treasury and long stock index positions. FSE, at just $2 million, is the smallest FactorShares product. Daily turnover averages 3,306 shares.
The Good and the Not-So-Good …
FactorShares are advertised as cost-effective and capital-efficient portfolio management tools that may provide diversification because of their low correlation with other asset classes. That's true enough. The ETFs are less expensive than trading and managing a comparable two-position spread portfolio. Each dollar invested in a FactorShares product provides approximately two dollars of long exposure and two dollars of short exposure — all without margin.
There's also dollar-neutrality. Each FactorShares portfolio is rebalanced daily so that the dollar value of its long futures position approximates the dollar value of its short futures position. Keep that word “daily” in mind. The funds' managers rebalance the portfolios through purchases and sales of futures contracts to get as close as possible to a +200 percent/-200 percent equilibrium at the end of each trading session. The consequence of such rebalancing is a return pattern that can vary significantly from the funds' daily proceeds. Just because a fund gives you 200 percent of gold's return in a single day doesn't mean you get twice bullion's monthly gain or loss.
Look back at the returns earned by the FSG (long gold/short stock) fund. From FSG's February inception through August, gold appreciated 30.2 percent while the S&P 500 benchmark slipped 6.7 percent. Holding two singletons — that is, unlevered and equally weighted long gold and short S&P positions — would have yielded an expected return of 36.9 percent. Doubling that gain would produce a spread return of 73.8 percent without rebalancing. FSG's daily tweaking, however, produced a compound gain of just 69.4 percent for the period.
There's a good side to this, however. Over the same February-August period, the long bond/short stock portfolio (FSA) earned 41.1 percent instead of the 52 percent gain that would have been derived without daily rebalancing. Rebalancing actually cut losses for FSA's opposite number — the long stock/short bond FSE fund — which gave up only 39.8 percent since inception.
There are some other considerations for investors and advisors to keep in mind. First, some intraday FactorShares quotes may reflect substantial tracking error. Remember, the portfolios are rebalanced only at the end of the trading session. Spreads between last sale prices and end-of-day NAVs can also be wide. (See chart.)
Because FactorShares use futures contracts, contango and backwardation can significantly impact fund returns. Contango represents a premium — usually made up of finance charges, insurance and storage costs — built into the prices of deferred delivery contracts. When, for example, crude oil for December delivery sells for $88 a barrel when October oil is bid at $86, the market exhibits a $2 contango. A contango is likely to exist in a market for a storable commodity when there is a surfeit of supply.
When there's an extreme shortage of a commodity, however, the futures market can invert (become “backward”). In an inverted market, prices for deferred deliveries can fall below that of the nearby months as demand for immediate delivery heats up.
Long positions in futures that are rolled forward — what the managers of the FOL portfolio must do to maintain its constant oil exposure — absorb losses in a contangoed market as they sell low-priced contracts and replace them with more expensive futures. If the contango is deep and/or persistent, the return on the long oil side of the spread could turn negative, even if spot oil price rises.
And last, investors should be aware that FactorShares are not mutual funds, but commodity pools. At year end, investors receive a Form K-1 for tax purposes. That may add to their accounting costs.
Source for all tables: Brad Zigler