Owen

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

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.

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

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.