User:Glorat/Using futures to replicate index funds

Bogleheads philosophy encourages buying and holding of index funds. Unfortunately, for non-US persons, the UCITS funds that investors will consider have higher Total Expense Ratio (TER) costs than their US equivalents as well as be subject to 15-30% dividend tax on their US holdings (whereas US persons do not have this tax). The following strategy allows some qualified individuals to avoid both the management fee and withholding tax.

Introduction
This content is based on the forum discussion at.

Prerequisites
For this strategy to even be applicable to you, you almost need to have:
 * No capital gains tax
 * No other tax related overhead when buying and selling futures
 * A broker with access to trading futures and future spreads
 * A broker providing you with a margin loan facility
 * Looking to invest the equivalent of units beyond $10,000 USD
 * An understanding of Futures trading

You should also be aware up-front of the following issues
 * Trading futures and future spreads is a little tricky. It is easy to accidentally buy the wrong amount
 * Although this strategy does not use margin neither for leverage or borrowing, a margin account is being used and there are risks in accidentally using margin unexpectedly
 * The level of insurance or protection in the event certain entities (brokers etc.) go bust is unclear
 * Requires education and training in buying/selling futures and the underlying risks involved

The following assumptions will be made
 * It is assumed you do not want to take a leveraged position
 * It is assumed that while the broker margin facility exists, you want to minimise its use
 * You have at least a basic understanding of how Futures trading works

Investment Strategy
At the time of writing, Micro E-Mini Futures are available for the following US stock indices For the purposes of Bogleheads, the S&P 500 is the most relevant as a broad based large cap index that covers most of the US equity market. The Russell 2000 is also relevant to round out the mid-caps. However, given the minimum investment amounts involved, trying to acheive a market cap weighted total US market in a balanced way is too difficult, it is likely one will only pick the S&P 500. The rest of this wiki page will assume investment in the S&P 500
 * S&P 500
 * Nasdaq 100
 * Russell 2000
 * Dow Jones Industrial Average

The aim is to take the investor's available capital, e.g. $100,000 and invest in the equivalent of buying an S&P 500 ETF tracker such as VUSD, SPY or others - but without being subject to the ETF management costs or US witholding taxes.

Step 1: Achieve the long $100,000 S&P 500 position
The future to take a position is the ticker "MES". There will be many dates - choose the one closest to expiry. The above expires on 18-Dec-2020.

The price of MES (e.g. $3500) must be multiplied by 5 to get the equivalent S&P position (e.g. $17,500). You cannot buy fractions of a future. The number of MES contracts you should buy will be approximately $100,000/$17,500, then rounded down (assuming you want to avoid being leveraged).

Thus you will go long 5 MES contracts for a value of $17,500 - but this will have a net-asset value of $87,500. This less than the desired $100,000 position but this is the issue with futures contracts being in such large sizes. (These are already smaller than the previous e-mini futures, not to mention the full size futures used by large traders)

Step 2: Fund the Futures position
Although you have now established your S&P 500 position, there are two issues
 * The MES total return will be dragged down by a funding cost, based on treasury rates
 * You have a large cash balance sitting in your account - it is both not earning and it is generally a Bad Idea to have cash sitting in a broker account

Both issues can be solved with the same solution. Use your $100,000 cash balance to purchase short term US treasuries or some other money market equivalent. Ensure you choose an option with high liquidity and low bid/ask spreads since you may need to occasionally trade in and out in Step 3

One valid option for non-US persons preferring UCITS ETFs is the iShares ETF with ticker IB01

Step 3: Rolling over futures every 3 months
Futures contracts expire every third month (Mar, Jun, Sep, Dec) on the 3rd Wednesday. If no action is taken, on the day of expiry, your future position will automatically be closed, given you a cash credit based on the value of the S&P 500 on the closing date. At that point, you will effectively have a 100% treasury position, rather than a 100% S&P 500 position. Not what you want!

To ensure this does not happen, at some point before expiry, you will need to sell your Future and simultaneously buy a Future with the next expiry date. For example, if you hold the Dec20 Future, then some day before 20th December 2020, you need to sell the Dec20 Future and buy the Mar21 future. To ensure these two trades happen simulataneously, you should execute a "Futures Spread" trade that does this together. The cost of entering this trade is based on the difference between the two Futures contracts (and so the cost may be negative).

It seems that it is not overly important when to roll the future as long as it is before expiry. The later you leave it, the tighter the bid/ask spreads. Too late and you might forget. However, given the liquidity of Futures, the bid/ask spreads will be very tight even several weeks before expiry.

Step 4: Maintaining margin and cash balance
Holding Futures creates a margin requirement in your account. This will be maintained not by cash but by holding a sizeable Treasuries position whose collateral will cover the margin requirement. Also, in order to replicate a non-leveraged long equivalent position in the S&P 500, funding costs need to be netted with the Treasury position from Step 2.

TBD - need some help describing how to balance out the Treasury position as S&P moves, while still ensuring margin calls are near zero and leverage is always at most 1x

Ideally, one wants to ensure that the cash balance is not much above zero (to minimise both opportunity cost and broker credit risk) nor much below zero (to avoid paying margin loan interest).