Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 3

Indexing with Synthetics and Futures

In this, the first strategy chapter, a leveraged index portfolio is constructed using options on ETFs to create synthetic positions. In order to generate higher returns, the portfolio is overweighted in both small-cap and value indexes, two categories that have historically outperformed the S&P 500 over time. The fund is designed to be a long-term, multiyear investment, although rapid short-term gains are possible in certain circumstances.

Even though this is the first strategy chapter of six, this is by no means simply an introductory or example strategy. This investment is designed to outperform the majority of the passive and actively managed equity funds in the marketplace over multiyear periods without a significant increase in long-term volatility.

This portfolio uses synthetics, which can be created by purchasing options that are available in every brokerage account. Synthetics are a proxy for owning an underlying stock or index on a leveraged basis. Synthetics can be replaced with futures contracts, and later in the chapter we make this substitution in order to lower the margin call risk and obtain higher levels of initial leverage.

ASSET ALLOCATION

This strategy uses its assets to purchase derivatives on a target asset allocation of shares of three exchange-traded funds (ETFs). We present the ETF performance and fund characteristics in Table 3.1 for each of these funds, and also provide those of the S&P 500 (SPY) for comparison. ...