Double Longs: An Equity Idea in a 6% World?

More of a theory than an idea.

All of the various double long products own t-bills to collateralize relatively small futures positions. The funds then pay out the interest taken in from the t-bills (less whatever the fee is).

If we are ever again in a world where t-bills yield 5-6% might it make sense to build a very simple portfolio (half portfolio really, with the other half in cash) of double long products?

This could allow the the investor to capture the market (remember the market goes up close to 3/4 of the time) plus 5%, or whatever t-bills are yielding.

First let me address interest rates. Rates are low by historical standards and at some point the US might try to defend the dollar--these points pave the way for higher rates.

Where I think the idea is interesting is that if equity returns continue to be below normal, then an extra 5% for people not comfortable with stock, sector or country selection would allow for having a better shot of adding value to their returns.

So what's not to like?

Well, the existing crop of double long products target daily movements of the underlying indexes. This means that over longer periods of time the fund may not capture twice the move of anything. In 2007 SSO lagged SPY and if you recall SPY was up a little for that year.

It's not that SSO didn't work, but that the objective is not to do its thing for more than one day. You can look at the various charts I have included on this post and decide for yourself how well, or not, the double long funds captured a double long effect over longer periods of time.

Now that you have looked at the charts and have an opinion about how well they do capture double long over extended periods of time, there is virtually no way the past result can be repeated. What you see on those charts came about from the combination, sequence and magnitude of all the up and down days that occurred during the time charted. Going forward the same combination, sequence and magnitude of all the up and down days will be different.

The combination over the next year or two could yield a result that looks a lot like double long or looks nothing like double long; there is no way to know.

So if that is the case, then what is the point? The current roster of products are daily only, but that does not make the concept any more or less valid. However, the right product to capture this does not currently exist. There exists a series of leveraged commodity funds whose objective is double long on a monthly basis (I think these are from PowerShares  DB, eg double-long gold DGP).

If double long on a monthly basis exists for commodities, can equities for the month or the quarter be that far behind? I am not aware of of any of these in the works but it seems logical and were funds like this ever to list and if t-bill rates were ever to go up toward 6% (remember they were about 5% not too long ago), then executing the theory becomes a little more feasible.

Comments

[Owen]

Ah, if it were only that easy! As any futures textbook will explain, equity index futures trade at a price which is different from the "cash" --or current--price. This difference corresponds to the cost of capital, in our case the interest on the T-Bills, minus the dividend yield of the underlying portfolio. In a 6% T-Bill, 2% dividend world, an S&P futures contract expiring 3 months away will cost about 1% more than the current S&P ((6-2)*(3/12)). This means that by the time the futures contract expires or is rolled over, the interest you've collected on your T-Bill is exactly offset by the premium you paid for the futures contract, or for the ETF which holds that contract. Whenever this futures-to-cash offset deviates by even a fraction of a point, index arbitrage players jump in to correct this imbalance, pocketing the small difference, which is only available to them since their transaction costs are negligible.

There is no free lunch in the index arbitrage world. No combination of T-Bills, futures and ETFs will yield 6% above the S&P, because if there were such a combination, arbitrageurs would buy this combination, short an equivalent amount of SPY or futures, and pocket the 6% risk-free difference without any capital outlay (arbs get the T-Bill rate on proceeds from short sales, which you and I don't). Investment banks have whole departments devoted to squeezing every penny out of the differences between S&P-based ETFs, S&P futures, SPX/OEX options, and the underlying 500 stocks. If you believe you've found a systemic discrepancy they've all missed, good luck to you.

[locke]

Do double-long funds pay double the dividends of the underlying index?

[Jake2]

"So if that is the case, then what is the point? The current roster of products are daily only, but that does not make the concept any more or less valid. However, the right product to capture this does not currently exist. (sic) There exists a series of leveraged commodity funds whose objective is double long on a monthly basis . . . " and so on.
I wish I could say that I was encouraged by this article but I wasn't. It struck me as being highly speculative, especially given low current T-Bill rates and other known and unknown financial exigencies. Saying that if "this" happens, then "that" will happen, or if "that" happens then "this" will result, is far beyond my ken.

[ETF Wanderer]

roger,

you mentioned that the double long products essentially hold two futures plus t-bills. what about products where the futures are illiquid or do not exist? for instance, UYG is double long financial stocks, but I am not sure if any future exist on financial stocks. how is the product contructed in this case?

thanks

[Owen]

etfwanderer,

UYG holds some of the stocks directly, but uses swap agreements with a counterparty to get additional exposure to the stocks in its portfolio. These are similar to the Single Stock Futures traded on the Chicago One Exchange, but unlike SSFs, swaps can be customized for the specific size and expiration (or no expiration at all), and can be on a basket of stocks rather than a single issue. Swaps do not trade on any exchange, and are often used to get around margin and other limitations. In this case, UYG uses these derivatives correctly to achieve a 2:1 leverage which would otherwise require less efficient instruments.

Just like with futures, however, there is no double dividend or free T-Bill interest, as those rates are factored into the price of the swap by the counterparty. This counterparty usually owns the underlying portfolio as a hedge, and has to finance its own capital. The "price" of the swap covers this financing cost.