Understanding using treasury futures for leverage to implement risk parity

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DonIce
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Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Thu Feb 21, 2019 7:58 pm

I've recently been reading about the idea of "risk parity" portfolios, for example the all weather portfolio from bridgewater. Based on their paper on engineering risks and returns, my understanding is that leverage is used to raise the expected returns (and associated volatility) of asset classes to a target level (for example, to approximately match the expected returns of equities), and then to diversify across these asset classes:

https://inside.bwater.com/publications/ ... plus_risks

So I'm interested in understanding how does one go about doing this within the context of an individual investor account. To simplify, I want to start by understanding how one could productively leverage treasury bonds, since they are one of the main asset classes that is frequently used to counterbalance the risk of equities as they have positive expected return and low (negative?) correlation with equities.

Borrowing money or using margin can be rejected immediately since borrowing rates for individual investors would typically be higher than the expected returns of treasuries. Leveraged treasury bond ETFs (for example, TYD) could be used but they have fairly high expense ratios and my understanding is that because they seek to replicate daily return x3 rather than long term return x3, the "volatility drag" will cause these ETFs to underperform the desired leveraged return in the long run. That leaves futures.

At first glance, the cost of buying and then quarterly rolling futures contracts on treasury notes (for example, the 10 year treasuy note future /ZN) seems well below the expense ratio of the ETF. My cursory (perhaps wrong?) understanding of futures tells me that the movement of the futures contract should match the movement of the underlying asset. That is, a long position in a future contract, rolled quarterly, should match the total long term performance of a long position in the underlying asset (of course, minus the costs of the relevant transactions fees, bid/ask spreads, etc).

However, when I look at the historical returns of the 10 year treasury note futures, for example here (data available from 1983):
https://www.investing.com/rates-bonds/u ... rical-data
and compare it to the historical returns of actually holding the 10 year treasury note, for example here:
http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html

I get an annual average annual return of about 1.3% for the futures (with a standard deviation of 7.5%), while holding the actual treasuries has an annual average annual return of about 7.4% (with a standard deviation of 9.5%) over the same time period.

So clearly I'm missing something about futures here. I've been reading some of the threads in the community here and it seems like there are some smart people that probably understand this stuff. Can someone help me to understand why the returns on the futures are seemingly so low in comparison to holding the underlying note?

Once I can get to the bottom of understanding this I'll have some follow up questions about the potential use of futures to create leverage in a portfolio to implement a risk parity strategy.

(And no, I'm not rushing off to implement some risky half-baked strategy based on things I don't fully understand, I'm just reading and curious to learn.)

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whodidntante
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by whodidntante » Thu Feb 21, 2019 8:44 pm

By buying and rolling treasury futures you will get similar performance to holding treasuries and shorting cash. So they are better at providing exposure to the term risk premium and to yield movements for a given amount of capital, then as a substitute for a bond fund. Treasury futures will work just fine for constructing a risk parity portfolio, so long as you understand what you own and how it acts.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by MotoTrojan » Thu Feb 21, 2019 8:50 pm

viewtopic.php?f=10&t=272007

Join the fun! I used to be pretty terrified about how these daily-rebalancing funds operate but now I am moving most of my Roth on over (small amount in the grand scheme of things). I also didn't realize it is indeed an ETF so the fund can't go out of business and leave me with nothing; the underlying assets would have to, and given modern-day circuit breakers in the market that is highly unlikely.

I personally am going 60/30/10 TMF/UPRO/DZK to include a little international exposure (same proportion I hold in my unleveraged portfolio).

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Thu Feb 21, 2019 8:57 pm

whodidntante wrote:
Thu Feb 21, 2019 8:44 pm
By buying and rolling treasury futures you will get similar performance to holding treasuries and shorting cash.
Right that's my understanding too but I'm not seeing that performance in the historical data that I linked. Am I misinterpreting it somehow? Or if it's too much trouble to sort through data at those links, do you know where I can look at to see the historical returns of holding treasury futures and compare it to holding the underlying treasuries so that I can verify that they differ only by the return rate of holding cash (short term t-bills)?
Treasury futures will work just fine for constructing a risk parity portfolio, so long as you understand what you own and how it acts.
Thanks, yes, trying to understand how it acts is the part I'm working on!

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Thu Feb 21, 2019 9:00 pm

MotoTrojan wrote:
Thu Feb 21, 2019 8:50 pm
viewtopic.php?f=10&t=272007

Join the fun! I used to be pretty terrified about how these daily-rebalancing funds operate but now I am moving most of my Roth on over (small amount in the grand scheme of things). I also didn't realize it is indeed an ETF so the fund can't go out of business and leave me with nothing; the underlying assets would have to, and given modern-day circuit breakers in the market that is highly unlikely.

I personally am going 60/30/10 TMF/UPRO/DZK to include a little international exposure (same proportion I hold in my unleveraged portfolio).
Thanks for the link! I've actually already started reading through that thread. I see that the strategy can be implemented with leveraged ETFs but I am really curious to understand how futures work well enough so that I could try to evaluate for myself whether it could be a better strategy to use futures to achieve the needed leverage rather than ETFs.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by HEDGEFUNDIE » Thu Feb 21, 2019 9:00 pm

DonIce wrote:
Thu Feb 21, 2019 7:58 pm
Borrowing money or using margin can be rejected immediately since borrowing rates for individual investors would typically be higher than the expected returns of treasuries.
You realize that to buy futures with leverage you need a margin account, right? At “borrowing rates for individual investors”.
Leveraged treasury bond ETFs (for example, TYD) could be used but they have fairly high expense ratios and my understanding is that because they seek to replicate daily return x3 rather than long term return x3, the "volatility drag" will cause these ETFs to underperform the desired leveraged return in the long run. That leaves futures.
Some true, sometimes false.

TMF since inception has had 1.4x the return of its index. UPRO has had 5.2x the return of its index. So 3x daily leverage does not ensure “underperformance”. It’s more accurate to say that you can target a precise amount of leverage return with futures.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by GrowthSeeker » Thu Feb 21, 2019 9:14 pm

OP,
I don’t know the answers to your questions, but I am interested in the answers.
Since part of what TMF (a 3x long bond ETF) does is to buy futures, you would think that an individual investor could do what they do wrt futures.
Just because you're paranoid doesn't mean they're NOT out to get you.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Day9 » Thu Feb 21, 2019 9:14 pm

This thread is more relevant than HEDGEFUNDIE's because user Rob Bertram uses treasury futures whereas HEDGEFUNDIE uses leveraged ETFs. A lot of good info in here.

Should I use margin to buy a balanced fund?
I'm just a fan of the person I got my user name from

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Thu Feb 21, 2019 9:18 pm

HEDGEFUNDIE wrote:
Thu Feb 21, 2019 9:00 pm
You realize that to buy futures with leverage you need a margin account, right? At “borrowing rates for individual investors”.
Right, but because of the high leverage ratio for treasury futures, the amount of money that is on margin at a brokerage and being charged interest on is very small compared to the value of the underlying asset controlled by the futures contract. For example, the maintenance margin on 1 futures contract (which controls $100,000 face value of treasuries) is like $1,500 or so. Am I missing something here? The brokerage is not actually charging you interest on $100,000, it's just charging interest on the $1,500, right? And not even that if you have $1,500 cash on deposit with them.
TMF since inception has had 1.4x the return of its index. UPRO has had 5.2x the return of its index. So 3x daily leverage does not ensure “underperformance”.
Right but UPRO started after the last big drop in stock prices (2008) so it's experienced a fairly smooth bull market with minor corrections, the ideal environment for a leveraged ETF like that to be able to grow. If you look at SSO, which started before 2008, I think its returns since inception (including dividends) are still a bit below if you had just invested in SPY.

It's definitely an interesting experiment you are discussing/implementing in the other thread, I'm just trying to understand an alternative approach to it though! In regards to portfolio design, if I can understand futures I was thinking of designing a portfolio that has an unleveraged position in equities and then uses futures to achieve the needed exposure to lower risk/return assets like treasuries.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by EfficientInvestor » Thu Feb 21, 2019 9:46 pm

DonIce wrote:
Thu Feb 21, 2019 9:18 pm
HEDGEFUNDIE wrote:
Thu Feb 21, 2019 9:00 pm
You realize that to buy futures with leverage you need a margin account, right? At “borrowing rates for individual investors”.
Right, but because of the high leverage ratio for treasury futures, the amount of money that is on margin at a brokerage and being charged interest on is very small compared to the value of the underlying asset controlled by the futures contract. For example, the maintenance margin on 1 futures contract (which controls $100,000 face value of treasuries) is like $1,500 or so. Am I missing something here? The brokerage is not actually charging you interest on $100,000, it's just charging interest on the $1,500, right? And not even that if you have $1,500 cash on deposit with them.
I'm still in the process of learning about futures, but let me give this a shot. Even though you may only need to put up $1,500 as margin/collateral to control $100k worth of the treasuries, you have to consider the costs and benefits associated with both sides of the transaction. The person on the other side of the trade has $100k wrapped up in treasuries that they have now promised to give to you at a certain date in the future. They should be compensated for the opportunity cost associated with that $100k. Therefore, they will charge you the risk free rate (let's say the fed fund or libor rate) for you getting the privilege of them having their money tied up instead of you. On the other hand, they are getting the benefit of the yield of those treasuries during the duration they are holding them. Therefore, that will be in your favor and discounted to you. For treasury futures, these two items generally make up the "cost of carry" and are baked into the futures price. Thus, the price of the futures contract will generally be, "Future Price = Current Spot Price + (Risk-Free Interest Rate - Yield)*Time". So in the end, you are paying the risk free interest rate on the full $100k. As whodidntante pointed out, you are long the yield but shorting cash (risk-free rate).

If others have anything to edit/add to the explanation, please chime in.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Beliavsky » Thu Feb 21, 2019 10:06 pm

DonIce wrote:
Thu Feb 21, 2019 7:58 pm
However, when I look at the historical returns of the 10 year treasury note futures, for example here (data available from 1983):
https://www.investing.com/rates-bonds/u ... rical-data
and compare it to the historical returns of actually holding the 10 year treasury note, for example here:
http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html

I get an annual average annual return of about 1.3% for the futures (with a standard deviation of 7.5%), while holding the actual treasuries has an annual average annual return of about 7.4% (with a standard deviation of 9.5%) over the same time period.

So clearly I'm missing something about futures here.
Futures contracts have margin requirements that are a small fraction of the notional exposure, and that margin can be held in Treasury bills. Thus futures give you exposure to the *excess* returns of the underlying. So you should add the average T-bill yield over the historical period to obtain the returns of synthetic fully-collateralized Treasury notes from the futures markets. In other words, you have found that synthetic Treasury notes have had excess returns of 1.3% a year over T-bills over the time period.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Thu Feb 21, 2019 10:38 pm

Thanks EfficientInvestor and Beliavsky. Looking at the link in my original post, the risk free rate (3 month T-bills) over the 1983-2018 period averaged 3.7% annually.

Subtracting 3.7% from 7.4% still leaves another 3.7% as the excess return I would have expected the "synthetic treasury notes" to have had. Not 1.3%. So somewhere there's still 2.4% missing. That seems close to the inflation rate, am I missing that in there somewhere? I don't think either of the links I listed are adjusted for inflation, though, so it shouldn't have been a factor in the calculation.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by EfficientInvestor » Thu Feb 21, 2019 10:55 pm

DonIce wrote:
Thu Feb 21, 2019 10:38 pm
Thanks EfficientInvestor and Beliavsky. Looking at the link in my original post, the risk free rate (3 month T-bills) over the 1983-2018 period averaged 3.7% annually.

Subtracting 3.7% from 7.4% still leaves another 3.7% as the excess return I would have expected the "synthetic treasury notes" to have had. Not 1.3%. So somewhere there's still 2.4% missing. That seems close to the inflation rate, am I missing that in there somewhere? I don't think either of the links I listed are adjusted for inflation, though, so it shouldn't have been a factor in the calculation.
If you are comparing the use of futures to just being long a 10-year treasury fund, you have to make sure you are doing so in an apples to apples manner by assuming you have the same amount of capital at your disposal in both cases. Let’s assume $100k. The 7.4% result happened by just putting $100k straight into a 10 year treasury bond fund. So it would be 7.4% minus expense ratios. For the futures, you would put $1,500 into the futures contract and the other $98,500 into a fund that returns the risk-free rate. Therefore, you are essentially offsetting 98.5% of the interest that is being charged to you in the futures contract. So you would get 7.4% - (1 - 0.985)*3.7% = 7.34%.

Can someone confirm this logic?

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by GrowthSeeker » Thu Feb 21, 2019 11:01 pm

I wonder if the best way to understand this is to look at a real price of a specific treasury future and see how it changes over time. There has to be devil in the details regarding how far into the future, when to sell that and buy the next one, what strike, what greeks (I assume futures have greeks like options).
Just because you're paranoid doesn't mean they're NOT out to get you.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Beliavsky » Fri Feb 22, 2019 7:34 am

DonIce wrote:
Thu Feb 21, 2019 10:38 pm
Thanks EfficientInvestor and Beliavsky. Looking at the link in my original post, the risk free rate (3 month T-bills) over the 1983-2018 period averaged 3.7% annually.

Subtracting 3.7% from 7.4% still leaves another 3.7% as the excess return I would have expected the "synthetic treasury notes" to have had. Not 1.3%. So somewhere there's still 2.4% missing. That seems close to the inflation rate, am I missing that in there somewhere? I don't think either of the links I listed are adjusted for inflation, though, so it shouldn't have been a factor in the calculation.
For a Treasury note or other futures contract, to get a single time series from which returns can be calculated, you will splice the prices of individual contracts, but adjustments must be made on the rollover dates, to get what futures traders call "continuous contracts". Your site likely has not done this. A relevant article is Continuous Futures Contracts for Backtesting Purposes. I have used ratio-adjusted futures data from Pinnacle Data in my futures backtests. Quandl says they have continuous futures contracts. The task of creating continuous contracts for backtesting is so common that almost every vendor of futures data will provide continuous contract data in addition to the raw contract data.

A true Boglehead does not trade futures. I admit to not being one :). A good site for active traders, including futures traders, is Elite Trader, where many traders can recommend data sources for futures.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Fri Feb 22, 2019 12:08 pm

Beliavsky wrote:
Fri Feb 22, 2019 7:34 am
For a Treasury note or other futures contract, to get a single time series from which returns can be calculated, you will splice the prices of individual contracts, but adjustments must be made on the rollover dates, to get what futures traders call "continuous contracts". Your site likely has not done this.
Thank you, I think that's the piece I was missing. Looking around the internet, it seems that this index here tracks the performance of holding the nearest 10 year treasury note contract and rolling it quarterly:

https://us.spindices.com/indices/fixed- ... turn-index

Does that look right to you for showing the return of what I'm trying to do here?

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Beliavsky » Fri Feb 22, 2019 12:30 pm

DonIce wrote:
Fri Feb 22, 2019 12:08 pm
Beliavsky wrote:
Fri Feb 22, 2019 7:34 am
For a Treasury note or other futures contract, to get a single time series from which returns can be calculated, you will splice the prices of individual contracts, but adjustments must be made on the rollover dates, to get what futures traders call "continuous contracts". Your site likely has not done this.
Thank you, I think that's the piece I was missing. Looking around the internet, it seems that this index here tracks the performance of holding the nearest 10 year treasury note contract and rolling it quarterly:

https://us.spindices.com/indices/fixed- ... turn-index

Does that look right to you for showing the return of what I'm trying to do here?
I am very confident that S&P has quants who know how to construct total return indices from futures, but for some reason that link is not working for me now. I will try it later.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Fri Feb 22, 2019 12:40 pm

Beliavsky wrote:
Fri Feb 22, 2019 12:30 pm
I am very confident that S&P has quants who know how to construct total return indices from futures,
Of course. It's more of a verification of if I am correctly understanding the intent of the index, rather than if they did it right :)
but for some reason that link is not working for me now. I will try it later.
Ticker symbol: SPUSTTTR

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Fri Feb 22, 2019 3:20 pm

Ok so next step, lets say accepting that holding a position in treasury note futures contracts and rolling the contract quarterly returns the 10 year treasury note rate minus the 3 month t bill rate. According to the index I linked above, the return has been 2.99% and the standard deviation has been 4.73%. Lets just accept these numbers for now.

Lets say for the equity portion of the portfolio we look at just the S&P500 index. This has had a historical return of 11.36% (not inflation adjusted) and a standard deviation of 19.58%.

Following the strategy described in the bridgewater paper linked in the original post, a 3.8x leveraged position (11.36/2.99 = 3.8) in the treasury note futures contracts would have a matching return of 11.36% as the S&P500 index, along with a standard deviation of 17.97%, so an almost identical risk/return profile as holding the S&P500 index.

Since these two are not correlated (historically, I know the future could always have different results than the past), then holding an equity position along with a 3.8x larger risk exposure in treasury futures should reduce the overall portfolio risk.

If I wanted to approximately duplicate the performance of a fairly conservative 40% stock 60% 10-year treasury note portfolio (lets say it was $1 million in stocks and $1.5 million in bonds), then I could hold $1 million in stocks, 12 ($1.5 million / 122,000 notional exposure per contract = 12.3, rounding down to 12) 10-year treasury note futures contracts (which has a margin requirement of $1265*12 = $15180), and place the other $1.5 million of capital in 3 month T-bills. These two approaches would generate identical performance (minus trading costs, etc), right?

If I wanted to use the 3.8x factor listed above so that stocks and bonds have an equal impact on the portfolio, that would be equivalent to 21% stock 79% bond portfolio. But rather than reducing the equity exposure from 40% to 21% and sacrificing returns relative to the 40/60 portfolio, I could still put 40% ($1 million) in equity, and then I would want a $3.8 million exposure to the treasury notes, which I could achieve with 31 futures contracts. Overall, this would be a (3.8 + 1)/2.5 = 1.92x leveraged position (since it controls $4.8 million in assets with $2.5 million in capital).

Lets say I wanted to target the overall return of equities but with lower risk through risk parity. In this case, half the return should come from stocks and the other half from the position in treasury note futures. Then, I would place $1.25 million in stocks, buy 39 futures contracts ($1.25 million * 3.8 / $122k per contract = 39) at a margin cost of $49k, and hold the remaining $1.25 million in 3-month treasury bills. This portfolio should have an equivalent long term return as just holding 100% stocks, but with a lower risk, assuming that past returns and standard deviations of stocks relative to 10 year bonds continue to behave in an uncorrelated way and maintain their historical standard deviations. Overall, this would be a (1.25 + 39*0.122)/2.5 = 2.40x leveraged position (since it controls $6.01 million in assets with $2.5 million in capital).

On the other hand, lets say I wanted to target double the overall return of equities, at a higher risk than the above portfolio but a lower risk than just holding 2x leveraged equities. Then, I would place $2.405 million in stocks, buy 75 futures contracts ($2.405 million * 3.8 / $122k per contract = 75) at a margin cost of $95k, and hold $95k in 3 month treasury bills. This portfolio should have about double the long term return as just holding 100% stocks, assuming that past returns and standard deviations of stocks relative to 10 year bonds continue to behave in an uncorrelated way and maintain their historical standard deviations. Overall, this would be a (2.405 + 75*0.122)/2.5 = 4.62x leveraged position (since it controls $11.55 million in assets with $2.5 million in capital). Obviously at this level of leverage there may be a substantial risk of wipe out, margin call, etc, but just trying to understand if I have the scaling of the leverage and the relative allocations between stocks and futures contracts right.

Am I on the right track so far?

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rmelvey » Fri Feb 22, 2019 3:34 pm

I have had interest in using futures for a passive buy and hold stock/treasury/gold portfolio because of the cheap leverage, but I keep talking myself out of it because of the taxes. With futures you have to pay tax each year on your P&L marked to market, so you completely give up the tax deferral benefit of buy and hold equities... I suppose you could hold the equities directly and just use futures for the bonds. But then its even more explicit that you are really just taking a leveraged position in bonds with rates at historic lows... I can't quite make the mental jump to do that (and then have the discipline to blindly roll it each month!)

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Beliavsky » Fri Feb 22, 2019 5:06 pm

DonIce wrote:
Fri Feb 22, 2019 12:40 pm
Beliavsky wrote:
Fri Feb 22, 2019 12:30 pm
I am very confident that S&P has quants who know how to construct total return indices from futures,
Of course. It's more of a verification of if I am correctly understanding the intent of the index, rather than if they did it right :)
but for some reason that link is not working for me now. I will try it later.
Ticker symbol: SPUSTTTR
I looked at the site, and I think it has what you want -- total returns of a synthetic long Treasury note position created in the futures market.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by whodidntante » Fri Feb 22, 2019 7:13 pm

rmelvey wrote:
Fri Feb 22, 2019 3:34 pm
I have had interest in using futures for a passive buy and hold stock/treasury/gold portfolio because of the cheap leverage, but I keep talking myself out of it because of the taxes. With futures you have to pay tax each year on your P&L marked to market, so you completely give up the tax deferral benefit of buy and hold equities... I suppose you could hold the equities directly and just use futures for the bonds. But then its even more explicit that you are really just taking a leveraged position in bonds with rates at historic lows... I can't quite make the mental jump to do that (and then have the discipline to blindly roll it each month!)
Treasury futures are more tax efficient than treasuries in a lot of cases. I don't know how gold is taxed.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rmelvey » Fri Feb 22, 2019 9:32 pm

whodidntante wrote:
Fri Feb 22, 2019 7:13 pm
rmelvey wrote:
Fri Feb 22, 2019 3:34 pm
I have had interest in using futures for a passive buy and hold stock/treasury/gold portfolio because of the cheap leverage, but I keep talking myself out of it because of the taxes. With futures you have to pay tax each year on your P&L marked to market, so you completely give up the tax deferral benefit of buy and hold equities... I suppose you could hold the equities directly and just use futures for the bonds. But then its even more explicit that you are really just taking a leveraged position in bonds with rates at historic lows... I can't quite make the mental jump to do that (and then have the discipline to blindly roll it each month!)
Treasury futures are more tax efficient than treasuries in a lot of cases. I don't know how gold is taxed.
Gold is tax efficient held on its own. So yes I think that futures make the most sense for treasuries because you are converting ordinary income into partial capital gains... I am just worried about the combination of low rates and a flat yield curve. It makes leveraging Treasuries seem like risk with very little upside.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Sat Feb 23, 2019 2:32 am

A while back I started out doing basically what is being proposed here. Once you take a position in treasury futures, though, the historical sharpe ratio of short term treasuries has been substantially better than the 10 year treasuries... so if you're going to use leverage anyways, you might as well take a 5x larger position on the 2 year treasuries, rather than using the 10 year treasuries.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rmelvey » Sat Feb 23, 2019 3:10 am

rhe wrote:
Sat Feb 23, 2019 2:32 am
A while back I started out doing basically what is being proposed here. Once you take a position in treasury futures, though, the historical sharpe ratio of short term treasuries has been substantially better than the 10 year treasuries... so if you're going to use leverage anyways, you might as well take a 5x larger position on the 2 year treasuries, rather than using the 10 year treasuries.
Are you still using the strategy? If not, what caused you to stop?

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Sat Feb 23, 2019 6:52 pm

rmelvey wrote:
Sat Feb 23, 2019 3:10 am
Are you still using the strategy? If not, what caused you to stop?
I'm currently long 2 year bonds in a variety of currencies. It's a position that I'm reasonably confident will a be a good one to hold long term, based both on academic research and some more practitioner-oriented things I've read.

I also have some more "creative" positions that are basically yield curve steepener trades (e.g. short 30 year german bond, long 10 and 2 year). These I'm less sure about. I'm holding them partially for educational purposes. Hopefully tuition won't be too expensive!

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Mon Feb 25, 2019 2:53 pm

rmelvey wrote:
Fri Feb 22, 2019 3:34 pm
I have had interest in using futures for a passive buy and hold stock/treasury/gold portfolio because of the cheap leverage, but I keep talking myself out of it because of the taxes. With futures you have to pay tax each year on your P&L marked to market, so you completely give up the tax deferral benefit of buy and hold equities... I suppose you could hold the equities directly and just use futures for the bonds.
Yeah that's what I am contemplating here. In addition, given the low margin requirements for the treasuries you could hold all the needed futures contracts in a tax advantaged account even if you have a fairly large equity holding in a taxable account.

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Mon Feb 25, 2019 2:56 pm

rhe wrote:
Sat Feb 23, 2019 2:32 am
A while back I started out doing basically what is being proposed here. Once you take a position in treasury futures, though, the historical sharpe ratio of short term treasuries has been substantially better than the 10 year treasuries... so if you're going to use leverage anyways, you might as well take a 5x larger position on the 2 year treasuries, rather than using the 10 year treasuries.
Do you have a link to this historical information? I'd be interested to see it.

Also, any insights/thoughts on this strategy based on your experience with it so far?

Beliavsky
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Beliavsky » Mon Feb 25, 2019 4:34 pm

DonIce wrote:
Mon Feb 25, 2019 2:56 pm
rhe wrote:
Sat Feb 23, 2019 2:32 am
A while back I started out doing basically what is being proposed here. Once you take a position in treasury futures, though, the historical sharpe ratio of short term treasuries has been substantially better than the 10 year treasuries... so if you're going to use leverage anyways, you might as well take a 5x larger position on the 2 year treasuries, rather than using the 10 year treasuries.
Do you have a link to this historical information? I'd be interested to see it.

Also, any insights/thoughts on this strategy based on your experience with it so far?
There was a 2014 paper Yield Curve Carry by Galen Burghardt and Lianyan Liu that looked at going long Eurodollar futures in the U.S. and the equivalent in other countries. A strip of the first 8 Eurodollar futures (with quarterly expirations) will have returns highly correlated to the 2-year Treasury bond, except in a financial crisis such as 2008.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by HEDGEFUNDIE » Mon Feb 25, 2019 4:50 pm

DonIce wrote:
Mon Feb 25, 2019 2:53 pm
rmelvey wrote:
Fri Feb 22, 2019 3:34 pm
I have had interest in using futures for a passive buy and hold stock/treasury/gold portfolio because of the cheap leverage, but I keep talking myself out of it because of the taxes. With futures you have to pay tax each year on your P&L marked to market, so you completely give up the tax deferral benefit of buy and hold equities... I suppose you could hold the equities directly and just use futures for the bonds.
Yeah that's what I am contemplating here. In addition, given the low margin requirements for the treasuries you could hold all the needed futures contracts in a tax advantaged account even if you have a fairly large equity holding in a taxable account.
Tax-advantaged accounts have higher margin requirements than taxable accounts. You should look into whether your broker even allows futures trading in your IRA.

Beliavsky
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by Beliavsky » Mon Feb 25, 2019 5:47 pm

HEDGEFUNDIE wrote:
Mon Feb 25, 2019 4:50 pm
DonIce wrote:
Mon Feb 25, 2019 2:53 pm
rmelvey wrote:
Fri Feb 22, 2019 3:34 pm
I have had interest in using futures for a passive buy and hold stock/treasury/gold portfolio because of the cheap leverage, but I keep talking myself out of it because of the taxes. With futures you have to pay tax each year on your P&L marked to market, so you completely give up the tax deferral benefit of buy and hold equities... I suppose you could hold the equities directly and just use futures for the bonds.
Yeah that's what I am contemplating here. In addition, given the low margin requirements for the treasuries you could hold all the needed futures contracts in a tax advantaged account even if you have a fairly large equity holding in a taxable account.
Tax-advantaged accounts have higher margin requirements than taxable accounts. You should look into whether your broker even allows futures trading in your IRA.
According to a CME spreadsheet the margin for the 10-year Treasury note futures contract is $1150, and the price of the contract was recently about 122, so the dollar exposure is $122K. So margin is less than 1% of notional. I see that at TD Ameritrade IRA futures margin requirements are 125% of non-IRA margin requirements, so even there, margin is less than 1.25% of notional. Retail investors should be using much lower leverage than is being allowed. The margin requirement, even in an IRA, should not be the binding constraint.

rhe
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Mon Feb 25, 2019 6:36 pm

DonIce wrote:
Mon Feb 25, 2019 2:56 pm
rhe wrote:
Sat Feb 23, 2019 2:32 am
A while back I started out doing basically what is being proposed here. Once you take a position in treasury futures, though, the historical sharpe ratio of short term treasuries has been substantially better than the 10 year treasuries... so if you're going to use leverage anyways, you might as well take a 5x larger position on the 2 year treasuries, rather than using the 10 year treasuries.
Do you have a link to this historical information? I'd be interested to see it.

Also, any insights/thoughts on this strategy based on your experience with it so far?
Here is a practitioner note that gives a fair amount of info:
https://www.google.com/url?sa=t&source= ... v4Az-LTyPi

As another poster has pointed out, the best way to implement this sort of strategy seems to be with strips of eurodollar futures (and their equivalent in other currencies).

For academic research regarding why 2 year treasuries might have a higher sharpe ratio than 10 year treasuries, search for "leverage aversion" or "betting against beta". I don't work in this area but my impression is that these results aren't universally accepted. The papers did convince me to take a position, though.

klaus14
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by klaus14 » Mon Feb 25, 2019 6:55 pm

There is an ETF that does it for you: NTSX
expense ratio is reasonable: 0.20%
I am replacing my US Large allocation with this to achieve better risk parity.

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Tue Feb 26, 2019 1:02 am

klaus14 wrote:
Mon Feb 25, 2019 6:55 pm
There is an ETF that does it for you: NTSX
expense ratio is reasonable: 0.20%
I am replacing my US Large allocation with this to achieve better risk parity.
Hmm, interesting! That does look very similar to what I'm thinking about here. Having an ETF that does this for you would certainly simplify things. On the other hand, if I understand risk parity right, you'd want something more like 90% equity + 300% treasuries (or the same ratio at a lower leverage level), not 90% equity + 60% treasuries as this ETF does.
Last edited by DonIce on Tue Feb 26, 2019 1:11 am, edited 1 time in total.

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Tue Feb 26, 2019 1:02 am

Beliavsky wrote:
Mon Feb 25, 2019 4:34 pm
There was a 2014 paper Yield Curve Carry by Galen Burghardt and Lianyan Liu that looked at going long Eurodollar futures in the U.S. and the equivalent in other countries. A strip of the first 8 Eurodollar futures (with quarterly expirations) will have returns highly correlated to the 2-year Treasury bond, except in a financial crisis such as 2008.
Thanks! Interesting paper.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by klaus14 » Tue Feb 26, 2019 4:41 am

DonIce wrote:
Tue Feb 26, 2019 1:02 am
klaus14 wrote:
Mon Feb 25, 2019 6:55 pm
There is an ETF that does it for you: NTSX
expense ratio is reasonable: 0.20%
I am replacing my US Large allocation with this to achieve better risk parity.
Hmm, interesting! That does look very similar to what I'm thinking about here. Having an ETF that does this for you would certainly simplify things. On the other hand, if I understand risk parity right, you'd want something more like 90% equity + 300% treasuries (or the same ratio at a lower leverage level), not 90% equity + 60% treasuries as this ETF does.
Right. That's why I still also have separate bond allocation.
Still, that optimal ratio is very hard to achieve unless you are willing to accept low returns or pay up for leverage. I think instruments like NTSX helps you approach a better balance.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by HEDGEFUNDIE » Tue Feb 26, 2019 7:11 am

DonIce wrote:
Thu Feb 21, 2019 9:18 pm
It's definitely an interesting experiment you are discussing/implementing in the other thread, I'm just trying to understand an alternative approach to it though!
DonIce, upon reflection I think one of our previous backtesting methods in the other thread is actually equivalent to continuous futures backtesting.

Let’s say you wanted to lever up a 40/60 portfolio by 3x. In Portfolio Visualizer, going long 120% VFINX, 180% VUSTX, and going short -200% CASHX, should yield the same performance as equivalent notional exposure to futures contracts (and holding that cash in T-bills). Does that make sense?

I need to learn more about the “implied interest” that EfficientInvestor mentions is charged when you buy a futures contract. It doesn’t seem right to me that the implied interest you pay is at the risk-free rate.

The other concern I have is that you can’t precisely control your exposure or return when rebalancing. In other words, if you wanted to get back to 120/180/-200 at the end of the quarter, you would have to roll the whole contracts, perhaps sell or buy an extra ES or ZB contract to get (as close as you can) to the 120/180 split, and then either add or withdraw cash from the account so you are back to precisely a -200 cash position. This also makes calculating return somewhat more complicated, since you are constantly adding and subtracting funds.

Thoughts?
Last edited by HEDGEFUNDIE on Tue Feb 26, 2019 10:30 am, edited 3 times in total.

rhe
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Tue Feb 26, 2019 8:44 am

HEDGEFUNDIE wrote:
Tue Feb 26, 2019 7:11 am
perhaps sell or buy an extra ES or ZB contract
Are you sure you want to be using ZB (treasury bond) rather than ZN (treasury note)? Based on what I've read, you're getting really minimal returns on average for the extra duration risk. Also, I believe ZN is the most liquid of these futures, which could matter if a small scale nuclear war breaks out in east asia, for example.

There is also the ten year "ultra" future in between ZN and ZB, so you're actually two futures further out on the yield curve compared to what I would have expected.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Tue Feb 26, 2019 7:17 pm

klaus14 wrote:
Tue Feb 26, 2019 4:41 am
Right. That's why I still also have separate bond allocation.
Still, that optimal ratio is very hard to achieve unless you are willing to accept low returns or pay up for leverage.
Getting leverage through futures seems very cheap, though.

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DonIce
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Tue Feb 26, 2019 7:29 pm

HEDGEFUNDIE wrote:
Tue Feb 26, 2019 7:11 am
DonIce, upon reflection I think one of our previous backtesting methods in the other thread is actually equivalent to continuous futures backtesting.

Let’s say you wanted to lever up a 40/60 portfolio by 3x. In Portfolio Visualizer, going long 120% VFINX, 180% VUSTX, and going short -200% CASHX, should yield the same performance as equivalent notional exposure to futures contracts (and holding that cash in T-bills). Does that make sense?
Interesting! I was trying to backtest this idea on PV but couldn't figure out how to do it since the portfolio had to add up to 100% and I didn't realize you could do a negative allocation to cash. But yes, based on what I've read in this thread and learned in the last few days it seems like that allocation could be created by using futures contracts. I'll be playing with PV more now that you gave me this hint of using a negative cash allocation!
The other concern I have is that you can’t precisely control your exposure or return when rebalancing. In other words, if you wanted to get back to 120/180/-200 at the end of the quarter, you would have to roll the whole contracts, perhaps sell or buy an extra ES or ZB contract to get (as close as you can) to the 120/180 split, and then either add or withdraw cash from the account so you are back to precisely a -200 cash position.
A couple thoughts on this. First, I don't think its necessary to lever the equity part of the portfolio above 100%. Why not do 100/150 instead of 120/180 if you want that 4:6 ratio? That way you can hold the equities directly and thus minimize trading and tax costs. It also lets you consider diversifying your equity holdings more if you want (small caps, foreign stocks, etc), rather than relying on the ES futures which are just the S&P500.

Second, I don't think precise re-balancing is important. For example, if some quarters you are at 118/182 and others you are at 122/178 rather than your ideal 120/180, that will not materially impact your long term results.

Third, based on the discussion with other posters above and reading some of the papers they linked, it seems more advantageous to use lower duration treasury futures rather than longer ones, so perhaps the 5 year (ZF) rather than ZB.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by alex_686 » Tue Feb 26, 2019 7:51 pm

HEDGEFUNDIE wrote:
Tue Feb 26, 2019 7:11 am
I need to learn more about the “implied interest” that EfficientInvestor mentions is charged when you buy a futures contract. It doesn’t seem right to me that the implied interest you pay is at the risk-free rate.
It is pretty self evident if you look up the pricing formulas for futures and the "no abridge price".

Let see if I can do this from memory.

Lets say a lump of gold is worth $100 and the risk free interest rates was 1%. The 1 year future price of that lump of gold must be $101. If it were not then there would be some combination of trades For example, if the future price was $102, I could buy the lump of gold for $100, finance it for $1, and enter into the futures contract. Risklessly earning $1. And then lever it up 100 times.

And it has to be the risk free because big banks and hedge funds which can borrow at the risk free rate do this all of the time, squeezing the inefficiencies from the market.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by HEDGEFUNDIE » Tue Feb 26, 2019 8:24 pm

alex_686 wrote:
Tue Feb 26, 2019 7:51 pm
HEDGEFUNDIE wrote:
Tue Feb 26, 2019 7:11 am
I need to learn more about the “implied interest” that EfficientInvestor mentions is charged when you buy a futures contract. It doesn’t seem right to me that the implied interest you pay is at the risk-free rate.
It is pretty self evident if you look up the pricing formulas for futures and the "no abridge price".

Let see if I can do this from memory.

Lets say a lump of gold is worth $100 and the risk free interest rates was 1%. The 1 year future price of that lump of gold must be $101. If it were not then there would be some combination of trades For example, if the future price was $102, I could buy the lump of gold for $100, finance it for $1, and enter into the futures contract. Risklessly earning $1. And then lever it up 100 times.

And it has to be the risk free because big banks and hedge funds which can borrow at the risk free rate do this all of the time, squeezing the inefficiencies from the market.
Thanks this makes sense.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by alex_686 » Tue Feb 26, 2019 8:28 pm

HEDGEFUNDIE wrote:
Tue Feb 26, 2019 8:24 pm
Thanks this makes sense.
Note, abridge funds is one of the dozen flavors if hedge funds. This is all they do, find little flaws in the market and grind out pennies.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Tue Feb 26, 2019 11:50 pm

DonIce wrote:
Tue Feb 26, 2019 7:29 pm
perhaps the 5 year (ZF) rather than ZB.
Keep in mind that although ZN is a "ten year" treasury future, it actually currently behaves like a 6.5 year treasury. I think this is because rates are below the conversion formula rate and so generally the lowest duration treasury is delivered.

The cost of rolling these positions is small, but not so small you should ignore it. Don't forget that if you hold a strip of eurodollars, you can let the front contract expire and buy a new contract at the other end, which means you only roll a fraction of your position each quarter. With treasury futures you have to roll the whole position. I don't understand the details, but on interactive brokers I get what I think are "native" calendar spreads for rolling treasuries, which have tighter bid ask spreads than doing each leg separately.

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Re: Understanding using treasury futures for leverage to implement risk parity

Post by DonIce » Wed Feb 27, 2019 2:01 am

rhe wrote:
Tue Feb 26, 2019 11:50 pm
The cost of rolling these positions is small, but not so small you should ignore it. Don't forget that if you hold a strip of eurodollars, you can let the front contract expire and buy a new contract at the other end, which means you only roll a fraction of your position each quarter. With treasury futures you have to roll the whole position. I don't understand the details, but on interactive brokers I get what I think are "native" calendar spreads for rolling treasuries, which have tighter bid ask spreads than doing each leg separately.
Given the current size of my portfolio I think holding a strip of eurodollars would be far too much. But yes, point taken about minimizing trading costs.

rhe
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Wed Feb 27, 2019 6:18 am

DonIce wrote:
Wed Feb 27, 2019 2:01 am
Given the current size of my portfolio I think holding a strip of eurodollars would be far too much. But yes, point taken about minimizing trading costs.
Well, you could hold only every second or third quarter instead of holding a contract for every quarter like a "real" strip. Adjacent eurodollar contracts behave *very* similarly, except for the very front contract which basically just sits there.

A eurodollar contract is a million notional, but it's got a duration of 90 days, so basically it's going to have about the same response to an interest rate change as a $250k one year bond, or a $50k five year (zero coupon) bond. It's true the contract size looks huge, but because the duration is so low the price barely changes at all. If you do the math using the 0.25 year duration, you might be surprised by the result!

interestediniras
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by interestediniras » Sat Mar 02, 2019 4:02 am

I am trying to understand the feasibility of using futures in general rather than leveraged ETFs. I am a complete novice when it comes to futures, so I would appreciate some clarification on this basic question: is my impression correct that you need a very large amount of principal to successfully implement a leveraged portfolio with futures?

Let's say you have 200k of starting principal and you want to leverage that 3x split between ES and ZB contracts. My impression is that the notional value of one unit of each of these contracts is roughly in the range of ~100k. Let's assume each one is exactly 100k for simplicity. Then you would be able to achieve the desired result by purchasing 3 of each contract for 300k exposure to each underlying. But let's say you have 20k of starting principal. Is it accurate to say that this is totally impossible because you can't buy 0.3 of each contract? Since obviously the notional values are not exactly equivalent, and maybe one wants a more complex asset allocation (e.g. 30/40/15/15), it seems to get even worse.

The underlying motivation here is that ideally I would like a small exposure to a leveraged gold allocation, but I don't believe it will return past the risk free rate in the long run, so the effect of volatility drag will be horrendous. Really even TMF isn't great.

I may be totally wrong here, as I barely know what I'm talking about, so any help would be appreciated. Actually, thinking about it more, I guess it's not really an issue if you have roughly 100k+. Maybe this is what market timer meant in that other thread. Is it accurate to say that if the notional value of one EB contract was 100k, and you wanted 120k of exposure, you would just buy one contract along with 20k of SPY?

rhe
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Sun Mar 03, 2019 2:08 am

One contract of ZF ("five year" treasury futures) would give you 100k of exposure to something like a 4.2 year maturity treasury. Looking at the CME treasury analytics website, it looks like this is a quarter of a ZB contract. If you had 50k, you could hold 49k of some stock ETF, and then one ZF contract.

The more serious problem is that Interactive Brokers may charge an account fee for accounts under 100k, so I'm not sure whether there's a brokerage where this could be implemented in a cost efficient way.
interestediniras wrote:
Sat Mar 02, 2019 4:02 am
I am trying to understand the feasibility of using futures in general rather than leveraged ETFs. I am a complete novice when it comes to futures, so I would appreciate some clarification on this basic question: is my impression correct that you need a very large amount of principal to successfully implement a leveraged portfolio with futures?

Let's say you have 200k of starting principal and you want to leverage that 3x split between ES and ZB contracts. My impression is that the notional value of one unit of each of these contracts is roughly in the range of ~100k. Let's assume each one is exactly 100k for simplicity. Then you would be able to achieve the desired result by purchasing 3 of each contract for 300k exposure to each underlying. But let's say you have 20k of starting principal. Is it accurate to say that this is totally impossible because you can't buy 0.3 of each contract? Since obviously the notional values are not exactly equivalent, and maybe one wants a more complex asset allocation (e.g. 30/40/15/15), it seems to get even worse.

The underlying motivation here is that ideally I would like a small exposure to a leveraged gold allocation, but I don't believe it will return past the risk free rate in the long run, so the effect of volatility drag will be horrendous. Really even TMF isn't great.

I may be totally wrong here, as I barely know what I'm talking about, so any help would be appreciated. Actually, thinking about it more, I guess it's not really an issue if you have roughly 100k+. Maybe this is what market timer meant in that other thread. Is it accurate to say that if the notional value of one EB contract was 100k, and you wanted 120k of exposure, you would just buy one contract along with 20k of SPY?

interestediniras
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by interestediniras » Sun Mar 03, 2019 2:31 am

rhe wrote:
Sun Mar 03, 2019 2:08 am
One contract of ZF ("five year" treasury futures) would give you 100k of exposure to something like a 4.2 year maturity treasury. Looking at the CME treasury analytics website, it looks like this is a quarter of a ZB contract. If you had 50k, you could hold 49k of some stock ETF, and then one ZF contract.

The more serious problem is that Interactive Brokers may charge an account fee for accounts under 100k, so I'm not sure whether there's a brokerage where this could be implemented in a cost efficient way.
Thanks. And that would essentially be a 50/100 portfolio, if the 49k of equities were invested in an unlevered ETF? Or perhaps I could invest 48k in a triple leveraged ETF and hold two ZF contracts for an approximately 150/200 portfolio, right? I just want to check my understanding here.

The main issue is with my Roth account, which is far from 100k, and also has limited margin availability. Although with mega backdoor Roth contributions, that should only be the case for two more years or so.

it's frustrating that I have to choose between less granular asset allocation because of large futures contract sizes and fluctuating, often underperforming leverage from volatility drag in ETFs.

What would be the tax implications of implementing this kind of levered strategy portfolio with futures in taxable? I have over 100k there and risk parity is very attractive to me as a default strategy at the moment. But of course it's crucial that I have a full understanding of how this works first.

rhe
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Re: Understanding using treasury futures for leverage to implement risk parity

Post by rhe » Sun Mar 03, 2019 6:41 am

Well, if you have 50k to invest, and you put 49k in stocks, I'd say that's close to a 100% allocation to stocks! It's actually more challenging to put a "percentage allocation" on bonds once you're taking leveraged positions. A 100k position with ten year duration is more or less the same risk as a million dollar position with one year duration.

I spent a while thinking about this a few years back, and decided that it was too dangerous to have more than 100% exposure to stocks. I currently have about 90% stocks, a bond position in various two year bonds that would add up to maybe 200%, and then some additional bond positions that are steepener trades, and so are exposed to a different sort of interest rate risk.

To see why a leveraged position in stocks is dangerous, take a look at daily returns during the great depression. Anyone holding a leveraged position was forced to sell into losses, and was effectively wiped out. I suppose one could argue that the same thing could happen with bonds, but it seems like interest rates would probably be cut in this situation, rather than rising.
interestediniras wrote:
Sun Mar 03, 2019 2:31 am
Thanks. And that would essentially be a 50/100 portfolio, if the 49k of equities were invested in an unlevered ETF? Or perhaps I could invest 48k in a triple leveraged ETF and hold two ZF contracts for an approximately 150/200 portfolio, right? I just want to check my understanding here.

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