Enhanced Indexing
*Configured and optimistically presented to provide an informational value to all those with diverse experience levels.
For illustration purposes of this methodology, this core-satellite construction example requires two separate accounts, preference, one with ABC Brokerage Services and the other with any XYZ (futures) Commission Merchant. The ABC account represents the system’s core invested assets, and the XYZ futures account fulfills the function of the satellite hedging platform. All profits from the hedging discipline are redirected back into the core ABC account for continuous asset accumulation.
- ABC / 90% Aggregate Assets
The core portfolio will center on Exchange-Traded Fund (ETF) investments that route the broader market (S&P 500®) with acceptable margins of overlap and sector drip and have a low-priced expense ratio with a favorable dividend yield. On a pre-tax basis, dividends have accounted for a large percentage of the total returns over any lengthy investment journey. In the bargain, most ETFs are commission free, and coupled with zero transaction fees and low expense ratio fees, ETFs would be well-suited constituents for the core investment portfolio. By system design, the adaptive algorithms of the Z-alpha Trading System™ correlate with the S&P 500®.
Here’s a quote from Mr. Buffett in his annual letter to Berkshire shareholders in 2014 about his will: “My advice to the trustee couldn’t be simpler: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals…” – Z-alpha concurs only in part with Mr. Buffett as investors can add tremendous value by stripping away the 10% bond allocation and directly replacing those funds with a long-established bona fide hedged equity set of tactics.
Implementation: Allocate 90% of the earmarked assets into the core ABC brokerage account to purchase the designated ETF. This foundational constituent of the investment portfolio should never get sold. All additional ETF purchases (from hedging profits, reinvested dividends, etc.) will transpire when the core-satellite ratio needs occasional realignment. As delineated above and worth repeating, the strategy is to buy, forever hold, collect, protect, and repeat. On the condition that one follows this pattern for years, along with the added compounding generator of continual ETF accumulation from the hedging profits can produce favorable results.
- XYZ / 10% Aggregate Assets
This satellite account represents safeguarding by implementing futures for the hedged equity discipline. Trading futures offers many advantages such as round turn pricing, 24-hour trading opportunities, zero-time decay as with options, favorable 60/40 split on tax liability, ease of tax filing, and carryback losses, amongst others.
- E-mini
The E-mini-S&P 500® futures contract (ES) tracks the underlying Standard & Poor’s 500 stock index making the ABC account a good candidate for the (ES) for most bona fide hedging purposes. The (ES) is a fully electronic market that signifies all investors have access to the same Level II market and bid-ask spreads, which provides a “level playing field” and allows for quick online order execution. The E-mini-S&P 500® (ES) is the world’s most actively traded stock index futures contract, with millions of contracts daily. Considering that each contract is worth $50 times the current value of the S&P 500® index, one can see how enormous a market the (ES) represents, generating roughly $300 billion in order transactions per day. This size and continual activity equal a high degree of liquidity. The E-mini-S&P 500® (ES) futures contract maintains a very tight price spread of just a single tick (or $12.50 per contract), and since the price spread is considered a cost to enter the market, and the supportive price spread of (ES) is an enormous advantage for most hedged equity strategies. In the E-mini-S&P 500® futures market, investors usually are filled without slippage on large contract orders, and there are no restrictions on hedging or against going short.
- Margin Requirement
To initiate an (ES) position with XYZ Brokers, the current margin requirement to hold overnight (subject to adjustments) is approximately $12,650 per (ES) contract. For hedging purposes, the (ES) contracts are held overnight. Every (ES) contract, which has a notional value of $235,000, assuming you sell short the (ES) contract at $4,700 ($50 x $4,700), and with the initial margin requirement being $12,650, represents a deposit equaling 5.38% of the notional value of the underlying. So, for every sold short (ES) contract, investors can achieve $235,000 in asset protection. We also do not consider this leverage because the XYZ account will be in (short) neutrality (bona fide) with the core ABC account when hedging. Our investment process and preference allot $23,500 per (ES) contract as the margin limit to satisfy the system’s default requirement representing 10% of the notional value of the underlying. Note: Overnight margin requirements change periodically, as mentioned, and this example is strictly for illustration purposes only and not continuously monitored or updated to show the adjusted arithmetic.
- 24 Hour Trading
Since the (ES) futures contracts get cleared through the CME® Globex electronic exchange, these instruments are tradeable nearly 24 hours per day. The foremost hedging objective is to protect the core investment of ETF at the opportune time, and having a hedging tool available almost anytime begets optimal performance.
- Tax Benefits
The (ES) futures contracts are Section 1256 contracts that provide meaningful tax savings. These contracts have lower 60/40 tax rates, with 60% of trading profits taxed at the lower long-term capital gains rate and 40% of profits taxed at the short-term rate, regardless of your actual holding period.
Implementation: Allocate 10% of the total desired investment assets into the satellite XYZ account for hedging the core ABC account. For every $235K of ETF asset value, one (1) ES contract would be sold short for the ETF hedge, assuming the current value of the (ES) is $235,000. This strategy requires averaging down the needed contracts. Example: $426MM of ETF assets would require 543 (ES) contracts sold short for the bona fide hedge, equaling a 30% hedged equity stance.
ES contracts can be traded for less than $3 round turn. The trading fees in the above example requiring 543 contracts would equate to $1,629 in costs to obtain the 30% hedged equity stance. So, this would be preferable to selling 128MM in core assets to achieve the 30% hedged equity stance and incurring the capital gains tax.
Alpha: simplified.