Question for PMs and those familiar with using futures (in the real world): why don’t more investors/funds incorporate futures within their portfolios, particularly as an alternative to ordinary gearing (margin loans etc)?
Summation of my thoughts as follows:
*If an index/stock exposure can be created synthetically using long risk-free bond and futures over the stock/index, then so long as the return on the risk-free bond is less than the equivalent cost of margin lending (which as a rule, should be) then an investor should prefer to go long futures in preference to borrowing via margin/line of credit;
*The risk, of course, is that at maturity of the futures they have insufficient capital (or debt) to fulfil their end of the obligation. But as we are comparing this for the merits of source of lending, we could set the lose assumption that the investor does have a line of credit available (though not drawn until required to pay for the futures)
*Taking this a step further, assuming that the vast majority of companies within the index are running an appropriate capital structure where debt financing is used for projects that are value accretive (i.e, generating FCF in excess of cost of lending) then we should, over the long run, see company profits/disbursements increase at a rate related to their return on assets and levels of gearing; thus over the long-run we should see company profits increase substantially more than the risk-free rate.
*Because of this an investor should be able to effectively build an investment portfolio with borrowings equivalent to (1) risk free rate on portion of investment exposure held via futures, plus (2) the lending rate on their line of credit multiplied by accrued losses.
From an investment strategy perspective, the missing links here is the volatility of returns, investment cycles (particularly if investing in a specific company/industry) and tax. In this case cumulative losses must be considered. That said, being sensible about the whole thing there seems room to add moderate amounts of leverage for very little real risk.
Eg: say a portfolio of assets within an index returns an average 7% p.a. with standard deviation of 10%, while seasonally adjusted earnings growth averages 7% comprising 4% real growth, with a standard deviation of 6%, plus 3% inflation. Let’s say the risk free rate is 3%. In this case a three-sigma event might see the index fall 23%, earnings fall 11% (nom). The following year they get by a 2-sigma, index falls another 13%, earnings fall 5%. Assuming constant exposure to the market at each tranche of futures, the investor has lost 36% (index level fallen 33%) while earnings are down 15.5%. In other words RoA is up 26%. Not to suggest reversion to the mean it inevitable, but there comes a time where earnings exert force on price. In this hypothetical scenario, we might expect total price falls to not exceed 50% and earning falls not exceed 30%, in which case the investor may be comfortable using futures to obtain leverage up to, say, 100% of cash available for investment. Normal margin lending might cost us 5% or so, leaving an long-run expectant profit of around 2%, while futures (and risk free rate) would bump this to an expectant profit of 4%. In this case normal margin lending for 50% of the total value (rest being cash) would yield roughly 7% + (7%-5%) = 9%. If we can obtain the exposure through this synthetic leverage at a rate of 3% p.a. we could obtain the same equivalent 9% with only 33% total leverage. Or with 50% leverage we could shoot the lights out with a 11% return. Swings and roundabouts here…. But basically if the theory applies in the real world, then why the hell would we use bank lending to invest?
The question then is whether futures (in the real world) are in fact priced according to the risk-free rate, or whether this is a simplification made for the purpose of the curriculum??
Anyway, not sure if anyone has any experience or observations they can share.
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