Article Tools
If stocks deliver a virtually riskless 7% to 10% average annual return over the long run and investors can borrow at 4% to 6%, why not leverage the passive indexing approach to get 14% to 20% a year instead? This is the question explored by Tristan Yates' new book, Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance (John Wiley & Sons, November 2008).
It's a book that could easily have become an academic treatise wrapped in dense prose and mathematical equations. But Enhanced Indexing Strategies is an elegant exposition written with a clarity that obviously had a generalist audience in mind. The message is quite accessible to those investors who have a basic idea of futures contracts/stock options and aren't averse to illustrative numerical tables.
Yates was one of the first to point out — in articles appearing on Investopedia.com and seekingalpha.com during 2007 — the pitfalls of leveraged exchange-traded funds (ETFs) for long-term index investors. His book builds on those critiques and shows how long-term investors can do leveraged index investing better on their own.
One way is to buy two-year LEAPS call options on indexes/ETFs and roll them over annually into new LEAPS. Margin calls are not a worry and the implicit cost of capital (the broker rate less dividends) is one of the lowest to be found (certainly better than margin debt).
When deep in-the-money LEAPS are used (e.g. strike price 20% below index level), time decay (theta) and sensitivity to volatility (vega) are low, allowing the portfolio of LEAPS to be more influenced by price changes in the underlying index (delta). The cost of rolling over the LEAPS will be close to the cost of capital and it will be predictable, making it easy to budget for the stream of income required to service the roll.
Setting up a LEAPS portfolio immediately after a market decline is not advised. During a market decline, volatility usually spikes upwards and the gradual return to normal levels can offset gains in the prices of stock/index options. Yates recommends waiting for volatility to subside (which occurs after some market appreciation) or else buying deeper-in-the-money options.
Leveraged indexing won't be every investor's cup of tea. One reason is that it has to clear the hurdle of borrowing costs to break even (Yates used a cost of capital equal to 5% in his LEAPS simulations). "As a rule, rolled LEAPS calls are only profitable in the long-term when the cumulative index appreciation is higher than the cost of capital built into the options," writes Yates.
Some investors may not want to make this assumption. They may be concerned that growing structural imbalances in the U.S. economy portend a lower return on stocks than the historical average. If actual annual gains average only 1% to 5% over the next decade or two, the unleveraged index investor will earn that return at least, whereas the leveraged index investor will not.
Yates' book goes into many other aspects of leveraging index portfolios, including rebalancing, reinvesting gains, choice of index, and hedging. He covers other strategies besides LEAPS options. In addition to his book, more can be learned about the author and his work at website indexRoll.com.
Rate this article
