Updated for 2021
*Configured and optimistically presented to provide an informational value to all those with diverse experience levels.
This core-satellite construction requires the investment professional to have two separate accounts, one with Vanguard Brokerage Services and the other with any (FCM) futures commission merchant. For the illustration of this methodology, we will feature Interactive Brokers (futures). The Vanguard account will represent the system’s core invested assets, whereas the futures account will serve as the satellite hedging instrument. All overflow monies from the hedging discipline will be transferred into the core Vanguard account for continuous asset accumulation or CAA. Overflow is considered any value (>10%) of the system’s hedging default.
- Vanguard / 90% Aggregate Assets
The Vanguard Group reported approximately $7.1 trillion in assets under management last year, maintaining its position as the world’s largest provider of mutual funds and the second-largest provider of ETFs in the world. With more than $1 trillion in ETF assets under management, our focus will be the ETF arena. With this in mind, one of the premier index funds is the Vanguard 500 Index Fund (VOO). This fund tracks the S&P 500® and is repeatedly the lowest cost way to do so with an expense ratio of just 0.03% and as low as 0.01% for larger holders. Note: Z-alpha Signal™ algorithms are correlated to the S&P 500® and beta neutral instruments. Note: Because investors in all the Vanguard funds are the owners of the funds, this structure of investor-owned allows Vanguard to avoid any conflicts of interest.
The VOO benefits from having a more modernistic legal structure that allows for the reinvestment of dividend payments and securities lending, which then results in the easier execution of the strategy. On a pretax basis, dividends have accounted for a large percentage of the total return of the S&P 500® over the long term. This additional value can materialize for investors looking to capitalize on the combination of dividend increases and dividend reinvestment with the VOO ETF currently yielding ≈1.42%. Furthermore, investors never pay a commission to buy the VOO in the core Vanguard account. With zero transaction fees and the lowest expense ratio fees in the ETF universe, using VOO as the core investment would be an acceptable product for this particular methodology.
Here’s a quote from Mr. Buffet in his annual letter to Berkshire shareholders in 2014 about his will: “My advice to the trustee couldn’t be more simple: 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…” – We agree in part with Mr. Buffet. Divergently, 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 strategy.
Implementation: Allocate 90% of the total desired investment assets into the core Vanguard account for purchasing the VOO ETF. Remember, this portion of the investment portfolio should never, ever be sold. Going forward, all additional VOO purchases (from hedging, reinvested dividends, etc.) will execute when the core-satellite ratio needs realignment. The strategy is to buy, hold, collect, protect, and repeat. By doing this pattern for years, with the added compounding generator of continual VOO accumulation from hedging profits, will produce staggering results.
- Interactive Brokers / 10% Aggregate Assets
Interactive Brokers has equity capital exceeding $9 billion and supports a conservative balance sheet. In addition, IB holds no material positions in OTC securities or derivatives. Interactive Brokers’ Trader Workstation is considered one of the top-ranking platforms available for investors. With highly competitive commission rates, more than 50 different order types, low margin rates, support for every investment imaginable, and trading in more than 100 universal markets, Interactive Brokers would meet our electronic requirements. This account would represent the satellite composition and will integrate 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 your tax liability, ease of tax filing, carry back losses, and more. Futures are easily the preferred trading instrument for portfolio safeguarding, and the advantages of using futures cannot be overstated. Z-alpha Trading System illustrates its portfolio hedging methodology as the (sell) signal representing a hedge on trade and the (buy) signal as the removal of the portfolio hedge.
The E-mini S&P 500® futures contract (ES) is based on the underlying Standard & Poor’s 500 stock index. This makes the VOO precisely correlated with the (ES) for genuine bona fide hedging purposes. The (ES) is a fully electronic market which means all investors have access to the same Level II market and bid-ask spreads, which provides an equal 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 traded daily. When considering that each contract is worth $50 times the current value of the S&P 500® index, one can see just how enormous a market the (ES) represents, generating roughly $300 billion in order transactions per day. This size and continual activity make for a high degree of liquidity. During the normal trading hours, the E-mini S&P 500® (ES) futures contract maintains a very tight spread of just a single tick (or $12.50 per contract). Since the spread is considered a cost to enter the market, the very low spread of (ES) is a huge advantage for most hedging endeavors. In the E-mini S&P 500® futures market, investors can be filled without slippage on large contract orders, and there are no restrictions on hedging or against going short.
To initiate an (ES) position with Interactive Brokers, the current margin requirement to hold overnight (subject to adjustments) is approximately $12,000 per (ES) contract. For hedging purposes, the (ES) contracts are held overnight. Every (ES) contract, which has a notional value of $210,000, assuming you sell short the (ES) contract at $4,200 ($50 x $4,200), and with the initial margin requirement being $12,000, represents a deposit equaling 5.71% of the notional value of the underlying. So, for every sold short (ES) contract, investors can achieve $210,000 in asset protection. We do not consider this leverage because the IB account will be in (short) neutrality (bona fide) with the core Vanguard account when hedging. Our investment process and preference assigns $21,000 per (ES) contract as the margin limit to satisfy the system’s default requirement representing 10% of the notional value of the underlying.
- 24 Hour Trading
The (ES) is traded on the CME Globex electronic exchange, and this allows the contracts to be traded nearly 24 hours per day, allowing investors the ability to get in and out of positions whenever they choose. The foremost hedging objective is to protect the core investment of VOO at the opportune time. Having a hedging tool available anytime begets optimal performance, and during special situations, can transform into an investment edge.
- Tax Benefits
The (ES) is classified as a Section 1256 contract which makes available very meaningful tax savings. These contracts have lower 60/40 tax rates, meaning 60% of profits are taxed at the lower long-term capital gains rate, with only 40% of the profits being taxed at the short-term rate, regardless of your actual holding period.
Implementation: Allocate 10% of the total desired investment assets into the satellite IB account for hedging the core Vanguard account. For every $210K of VOO asset value, one (1) ES contract would be sold short for the VOO hedge, assuming the current value of the (ES) is $210,000. This strategy requires averaging down the needed contracts. Example: $426MM of VOO assets would require 608 (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 in execution fees in the above example, requiring 608 contracts would equate to $1,800 in costs to obtain the 30% hedged equity stance. This would be preferable to selling 128MM in core assets to achieve the 30% hedged equity stance and incurring the capital gains tax.