Did you know that it’s possible to earn free money when trading the S&P 500?
A few thoughts came together when constructing this strategy.
#1: Hedge funds
Hedge funds used to have fantastic performance until the 2008 recession, beating buy and hold in bull markets and bear markets alike. Since then, hedge funds have consistently underperformed the market. What changed? Some attribute this shift to a “shrinking alpha”, in which an increase in competition in the trading industry causes everyone’s returns to decrease.
Moreover, why do so many Wall Streeters hate the Federal Reserve so much? The level of animosity towards the Fed and QE is unbelievable, and the level of snarkiness in the finance industry is off the charts. Whenever the stock market goes up, snarky financial professionals attribute it to “the Plunge Protection Team, the evil Fed, government manipulation”, etc.
#2: Interest rates vs. dividend yield
In 2018, the Federal Reserve’s interest rate exceeded the S&P 500’s dividend yield for the first time in 10 years. While many market watchers viewed this as a long term bearish sign for the stock market, they completely missed the point.
#3: where your returns come from
Historically, approximately half of an investor’s returns in the S&P 500 came from dividends.
*This figure is a little distorted. Over the past 90 years, the S&P 500’s average annual return was 10%. Over the past 150 years, the S&P’s average annual return was 9%. In other words, the S&P’s returns pre-1929 was lower than the S&P’s returns post-1929. What changed? Inflation. Inflation was virtually nonexistent until the 1920s due to the gold standard. But when you adjust these returns for inflation, the stock market’s gains have been pretty consistent over the past 150 years.
It’s also worth noting that the S&P 500’s dividend yield has gone down over time. More and more companies are choosing to retain their earnings instead of relinquishing these earnings to investors via dividends. Either way, it’s the same thing. $1 in your pocket = $1 in the pocket of a company who’s stock you own. The only difference in the long run comes down to taxes.
This is why we say that we are underestimating the returns in some of our models. Some of our models’ returns only look at the S&P 500, and ignore the fact that a trader who uses the model will also benefit from the S&P’s dividend yield.
After talking to a hedge fund manager, it finally hit me. There is a little known strategy that allows hedge funds and traders to essentially trade the S&P 500 (similar to $SPY), while also getting PAID with free money.
In the past, hedge funds would trade a small portion of $ES (e-mini futures) while holding a lot of short term Treasury bills.
- The small position in $ES was equivalent to holding the S&P 500, no leverage (or $SPY)
- The large position in Treasury bills was essentially free money. In finance, “cash” and “near term Treasury bills” are synonymous because you can convert near term Treasury bills into cash at any time. Think of this like a deposit in the bank. If you hold $10,000 cash in your bank account, you are still being paid interest on that cash.
Futures contracts = trading with leverage.
There are futures contracts for everything. For the purposes of this article, we will look at $ES, also known as e-mini S&P 500 futures. $ES is a futures contract for the S&P 500.
When you trade $ES, you are required to put down an “initial margin” and then maintain a “maintenance margin”. The “maintenance margin” is more important than the “initial margin”. The maintenance margin is set by exchanges and your broker.
Since $ES is so widely traded, the maintenance margin tends to be rather stable from broker to broker. At the time of this writing, $ES’ maintenance margin = $6,000
Remember what we said: futures contracts = trading with leverage.
For every 1 point change in the S&P 500 Index, $ES goes up for down by $50. This is leverage.
- If the S&P goes up 1 point, your $ES goes up +$50
- If the S&P goes down 1 point, your $ES goes down -$50
The S&P 500 is currently at approximately 2800.
This means that the entire $ range of this contract is $140,000 (50 * 2800 = 140,000). This represents the maximum you can lose on $ES. If the S&P 500 falls from 2800 to zero, you will lose -$140,000
In a way, this is like being leveraged 23.333x
You are using $6,000 to command $140,000. 140,000 / 6,000 = 23.3333
The free money
Now let’s assume that you don’t want to trade with leverage. What do you do?
Use only 4.28% of your account to buy $ES.
100% / 23.3333 = 0.0428
When you use only 4.28% of your account to buy $ES, you are essentially 100% long the S&P because you are using 23.33x leverage
We have just
- Used a fraction of our account
- To trade a leveraged financial product
- The small position size & leveraged position completely offset each other, = 100% long the S&P
Here’s where the free money comes in.
With the other 95.71% of cash that you hold, you can put that into short term government Treasury bonds. In other words,
- Hold a small $ES position that’s equivalent to 100% long the S&P 500
- Hold a very big position in short term government bonds that yields interest.
Immediately, you can see how this is better than just holding the S&P 500. You earn an additional few percentage points from holding the massive government bond position.
Let’s assume that the S&P yields 7% this year. With your $ES position, you will make 7%. Let’s assume that the 3 month Treasury yield is 2% right now. With a 95.71 position in bonds, you earn an additional 1.9% from your bond holdings.
- Before, you would have earned 7% just from holding the S&P
- Now, you earned 8.9% from holding $ES and government bonds (7%+1.9% = 8.9%)
- Before, you would have earned 7% just from holding the S&P
- Now, you earned 11% from holding $ES and government bonds
This explains why:
- Hedge funds used to consistently outperform the S&P index.
- So many professionals hate the Federal Reserve.
It is really easy to outperform the S&P when interest rates are high. You can earn 5%+ a year just from holding cash. This is why hedge funds had terrific performance in the 1980s and 1990s, and since then this performance has gone down. It’s hard not to outperform when you are earning 5% in free money.
*When a hedge fund / trader tells you “look at me, I’ve done so well over the past 20 years”, please look at where their performance comes from. Much of this outperformance comes not from the hedge fund manager’s skill, but from tricks that aren’t widely known to the public such as this one.
It’s also easy to see why so many professionals have a profound animosity for the Federal Reserve. By keeping interest rates at almost zero from 2008 – 2015, the Fed killed the only free lunch in the markets for professional traders and hedge fund managers. They can no longer dress up “tricks” as “alpha/skill”.
- “Tricks” can also be called “factors” in factor investing. Essentially, “tricks” (as I like to call them) are little-known things that ANYONE can do to increase his investment performance.
- Alpha/skill is outperformance that cannot be copied by others. It is generated by the SKILL of the individual trader/hedge fund manager.
A smaller cash position
You cannot hold 4.28% $ES and 95.71% bonds.
Because if the S&P falls by even 1 point, you will be hit with a margin call. Remember: you need to maintain $6,000 worth of margin per $ES contract.
This means that aside from the $6,000 you have in margin, you need to hold additional cash to buffer any temporary losses on your $ES position.
How much cash?
Holding 4.28% long $ES = 100% long the S&P
Hold as much cash as you think is your worst case scenario.
If, in a worst case scenario, the S&P can drop by 20%, then hold an additional 20% in cash. This means
- You are 4.28% long $ES
- You have 20% in cash
- You have 75.72% in short term government bonds (cash-like financial instruments, that can be converted into cash at any time).
If the market falls by more than -20% and eats up your 20% cash, then just sell some of your short term government bonds (e.g. 3 month Treasury bill). It is very hard to lose money on these instruments, which is why 3 month Treasury bills are often treated as the same thing as “cash”.
You profit when the S&P goes up. You also profit from the 75.72% you hold in short term Treasury bonds.
This strategy generally works better when you have a large sum of money. 1 $ES contract “costs” $6,000. To make $6,000 match 4.28%, you would need more than $1 million. If you only have $50,000 in your account, $6k = more than 10%, which is far more than 4.29%
Interest rates vs. dividend yield
This strategy only makes sense when interest rates exceed the S&P 500’s dividend yield.
Investors in the S&P 500 not only profit from the gain in the S&P 500’s value (e.g. if the S&P goes from 2700 to 2800), but they also profit from dividends that S&P 500 companies throw off.
Traders in $ES don’t earn this dividend yield.
- If you are 100% long $SPY and the S&P goes up 7%, you will earn 7% + the S&P 500’s dividend yield (e.g. an additional 2%). This brings the total to 9%
- If you are 4.28% long $ES and the S&P goes up 7%, you will only earn 7%.
- You can see that this strateyg worked from the 1960s all the way until the 2008 because interest rates were higher than the S&P’s dividend yield.
- This strategy didn’t work from 2008-2017 because interest rates were lower than the dividend yield. The Fed kept short term interest rates near zero.
Now that interest rates are back up, this strategy will start working again.
*Update: one of our members (Paul) made an interesting point. We have not taken into consideration the cost of rolling a long ES contract, which is currently 5.25 ES points per quarter (21 ES points per year).