How exactly do NTSX and PSLDX get leverage?

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tcrez
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Joined: Mon Mar 01, 2021 10:46 pm

How exactly do NTSX and PSLDX get leverage?

Post by tcrez »

Funds like NTSX https://www.wisdomtree.com/etfs/efficient-core/ntsx get a 90/60 exposure to stocks and treasuries by using treasury futures. I'd like more detail on how mathematically this all works. It's not intuitive to me when looking at future quotes like this https://www.investing.com/rates-bonds/us-10-yr-t-note how one can get free leverage.

I've watched a lot of YouTube on futures where they talk about corn prices and how farmers and manufactures can even out bumps in pricing by buying a contract (the futures) that requires them to buy many months in advance the corn at a fixed price. Thats easy to understand. However, when it comes to how you can get leverage on treasuries I have no clue.

The only way I can think of to get 90/60 is to take a 60/40 allocation of VOO/TLT or VOO/IEF and buy an 50% extra on margin. However, this wouldn't work well when the market is dropping as I'll be a a real risk of a margin call. Is there some other way to get 90/60 using futures? Also, if the market crashes, wouldn't the futures also crash and potentially wiping you out in a way that makes you unable to maintain the 90/60?

The same applies to PSLDX. It seems they get a 100% exposure to SPY in addition to the 100% bonds by buying S&P 500 futures and swaps. Is it possible for an ordinary investor to replicate this exactly? Also if SPY crashes hard, theres no wipeout situation ?
DMoogle
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Joined: Sat Oct 31, 2020 10:24 pm

Re: How exactly do NTSX and PSLDX get leverage?

Post by DMoogle »

Back to basics: a futures contract simply means that you've committed to purchase the asset some time in the future. The 10-year T-note contract is currently worth about $132k. HOWEVER, you don't *actually* need to have $132k in your account to buy the contract. You can have far, far less. This is because the guys that issue the futures know that the 10-year note is fairly stable, very liquid, and the odds of its value dropping dramatically is practically nil. In fact, according to https://www.cmegroup.com/markets/intere ... rgins.html, you only need $1,400 in your account for that $132k contract. Pretty crazy, right? It's fundamentally different from stock in that, with stock, you basically trade cash for your shares. For futures, you don't actually trade cash - you essentially buy the contract for "free," as long as you have some cash in your account in case the value goes down (and you get margin called).

So what would this look like in practice? Say you have $1m in your account and you want 90% equity/60% 10y treasury exposure. You could "buy" 4 10y contracts worth $528k (note no cash is deducted from your account), buy some shares of a treasury ETF for $72k, and then buy a stock ETF for $900k. Boom, 90/60.

On your question about everything crashing - few points to make:
  • Margin calls largely prevent people from losing more than their account's equity. I say "largely," because there have been some documented instances where the margin calls haven't worked properly, and people have reached negative equity in their account.
  • In a crash, there's no reason you wouldn't be able to maintain the 90/60 in one way or another. It just means your equity is lower than it once was.
  • Yes, margin calls are a real risk in a big crash, especially if you're highly leveraged. However, they aren't the devil they're made out to be. If you've lost equity, but you haven't rebalanced, then that means that your leverage has gone up (say if treasuries crashed, then your exposure might have gone up to 90/80, or if everything crashed, then maybe 130/75). Margin call is just a forced rebalance... something that the fund will do on its own normally.
Topic Author
tcrez
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Re: How exactly do NTSX and PSLDX get leverage?

Post by tcrez »

thanks for the detailed reply...

im curious to understand the downsides of such an approach...after all there is no free lunch right?

for a margin loan, the downside is of course having to pay interest. the broker can also raise rates anytime and you could be stuck with declining stocks/bonds and rising interest rates! and the worst possibility is a margin call which usually happens after a market crash so you'll be buying high and selling low!

for daily leveraged ETFs such as the 3x SPY or UPRO, the downside is the fees and serious decay that happens during market volatility due to daily resetting of leverage....

options can also get you leverage...but they can also wipe you out...if you buy an out of the money call on SPY, you have huge leverage if it eventually lands in the money, bu you're also wiped out if it doesn't...selling out of the money puts/options can net you some dividends but can wipe you out in a big market move

so the idea that i can put a small amount of money down in futures and get a 60% extra exposure to bonds still amazes me....

if this is the case, why stop at 60%? wouldn't i be able to go much higher and get say a 200% treasury bond exposure? sounds like a great deal if i can hold it forever....
DMoogle
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Re: How exactly do NTSX and PSLDX get leverage?

Post by DMoogle »

So a few points to address here:
joelin02 wrote: Tue Sep 21, 2021 10:41 amim curious to understand the downsides of such an approach...after all there is no free lunch right?
Kind of nitpicking and not totally relevant to your question, but there is one well-known free lunch in finance: diversification. With diversification, you can maintain an expected return while lowering risk.

More relevant to your question, futures are not interest-free. The price of futures contracts contains an implied interest rate. However, that rate tends to be a lot lower than margin rates (current rates are something like 0.5% for equity futures and 0.1% for treasury futures). More info here: https://www.investopedia.com/terms/i/impliedrate.asp. So why are margin rates so much higher? Mostly a convenience premium, really. Futures contracts are more complicated than margin and not as retail-friendly. I used IBKR's margin to gain leverage for years until I recently switched to futures and box spreads.
joelin02 wrote: Tue Sep 21, 2021 10:41 amfor daily leveraged ETFs such as the 3x SPY or UPRO, the downside is the fees and serious decay that happens during market volatility due to daily resetting of leverage....
LETFs actually use futures and swaps contracts. So in ADDITION to the 1% fee they charge, there's also the implied interest they pay via those contracts. So while the stated fee may be 1%, in reality for equities that's really more like 1%+0.5%. That's in ADDITION to the volatility decay. However, as some people have shown (see Hedgefundie's thread), volatility decay isn't necessarily quite as bad as some make it out to be.
joelin02 wrote: Tue Sep 21, 2021 10:41 amoptions can also get you leverage...but they can also wipe you out...if you buy an out of the money call on SPY, you have huge leverage if it eventually lands in the money, bu you're also wiped out if it doesn't...selling out of the money puts/options can net you some dividends but can wipe you out in a big market move

so the idea that i can put a small amount of money down in futures and get a 60% extra exposure to bonds still amazes me....
So I think you might be missing something here. For one: any investment can be wiped out, and leverage most certainly increases that risk. This is where risk management and diversification come into play. If you purchase a futures contract worth $132k and you only have that minimum $1,400 in your account, then basically any downtick in the market will cause your broker to liquidate you (i.e. sell the futures contract immediately). If that $132k drops to $131k (a 0.8% drop), your $1,400 is now worth $400 (a 70% drop). So yeah, being ~100:1 leveraged isn't recommended. :)
joelin02 wrote: Tue Sep 21, 2021 10:41 amif this is the case, why stop at 60%? wouldn't i be able to go much higher and get say a 200% treasury bond exposure? sounds like a great deal if i can hold it forever....
Yes, you absolutely can, and some have. It is a great deal if you can hold it forever, but that's the problem - NOBODY has an unlimited bankroll. In the scope of "forever," there will be crashes that, if you're too higher leveraged, you won't be able to adequately recover from. So that comes back to risk management and personal risk tolerance. Consider that not all bonds are the same, and I'd recommend reading this excellent thread that discusses leveraged strategies and outcomes of long-term vs. intermediate-term vs. short-term treasuries: viewtopic.php?f=10&t=357281

I personally have a very high risk tolerance. My taxable account is currently comprised of about 150% stocks and 300% intermediate-term treasuries (via futures). I wouldn't really recommend it to any of my friends.
BJJ_GUY
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Re: How exactly do NTSX and PSLDX get leverage?

Post by BJJ_GUY »

joelin02 wrote: Tue Sep 21, 2021 10:41 am thanks for the detailed reply...

im curious to understand the downsides of such an approach...after all there is no free lunch right?

for a margin loan, the downside is of course having to pay interest. the broker can also raise rates anytime and you could be stuck with declining stocks/bonds and rising interest rates! and the worst possibility is a margin call which usually happens after a market crash so you'll be buying high and selling low!

for daily leveraged ETFs such as the 3x SPY or UPRO, the downside is the fees and serious decay that happens during market volatility due to daily resetting of leverage....

options can also get you leverage...but they can also wipe you out...if you buy an out of the money call on SPY, you have huge leverage if it eventually lands in the money, bu you're also wiped out if it doesn't...selling out of the money puts/options can net you some dividends but can wipe you out in a big market move

so the idea that i can put a small amount of money down in futures and get a 60% extra exposure to bonds still amazes me....

if this is the case, why stop at 60%? wouldn't i be able to go much higher and get say a 200% treasury bond exposure? sounds like a great deal if i can hold it forever....
Based on your questions/comments above, consider the following to help clarify.

1. Gaining exposure to equity and fixed income via futures requires what is essentially a down payment as collateral. While referred to as margin, this isn't the same as borrowing via margin from your traditional brokerage. The margin posted for the futures transactions is a fraction of the notional exposure, so this is a very balance sheet friendly way to gain exposure (and leverage). The cash not used for initial margin is often held in short-term instruments that can be easily liquidated to raise cash, which is important, because cash will be required (maintenance margin) if your futures contracts lose value and your initial margin is no longer sufficient.

2. Options can provide leverage, and there is the potential to wipe you out, but not really when you're talking about being long calls and puts. If you buy OTM calls and they expire worthless, you simply lose the premium posted upfront. The leverage (convexity) is the non-linear pay-off profile (and that they do not require as much balance sheet as cash instruments, which is the similar benefit as futures). Selling options has more downside potential, though not something that can't be mitigated. Easiest way is to avoid being short options without more working knowledge.
j1mbo
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Joined: Thu Jan 06, 2022 12:03 pm

Re: How exactly do NTSX and PSLDX get leverage?

Post by j1mbo »

DMoogle wrote: Mon Sep 20, 2021 12:17 am Back to basics: a futures contract simply means that you've committed to purchase the asset some time in the future. The 10-year T-note contract is currently worth about $132k. HOWEVER, you don't *actually* need to have $132k in your account to buy the contract. You can have far, far less. This is because the guys that issue the futures know that the 10-year note is fairly stable, very liquid, and the odds of its value dropping dramatically is practically nil. In fact, according to https://www.cmegroup.com/markets/intere ... rgins.html, you only need $1,400 in your account for that $132k contract. Pretty crazy, right? It's fundamentally different from stock in that, with stock, you basically trade cash for your shares. For futures, you don't actually trade cash - you essentially buy the contract for "free," as long as you have some cash in your account in case the value goes down (and you get margin called).

So what would this look like in practice? Say you have $1m in your account and you want 90% equity/60% 10y treasury exposure. You could "buy" 4 10y contracts worth $528k (note no cash is deducted from your account), buy some shares of a treasury ETF for $72k, and then buy a stock ETF for $900k. Boom, 90/60.

On your question about everything crashing - few points to make:
  • Margin calls largely prevent people from losing more than their account's equity. I say "largely," because there have been some documented instances where the margin calls haven't worked properly, and people have reached negative equity in their account.
  • In a crash, there's no reason you wouldn't be able to maintain the 90/60 in one way or another. It just means your equity is lower than it once was.
  • Yes, margin calls are a real risk in a big crash, especially if you're highly leveraged. However, they aren't the devil they're made out to be. If you've lost equity, but you haven't rebalanced, then that means that your leverage has gone up (say if treasuries crashed, then your exposure might have gone up to 90/80, or if everything crashed, then maybe 130/75). Margin call is just a forced rebalance... something that the fund will do on its own normally.
So breaking it down even more layman's for me - if I buy that 528k in treasury futures, is that purely speculating over interest rate sensitivity? Or with risk free being about 4%, is there a discount to account for the coupon that I won't receive?

Or maybe another wording - does ntsx profit off the treasury future itself? Like market goes up and treasuries stay even, would they capture. 9x market and .6x interest? Or is the treasury future just exist to profit off decreasing interest rates which hedges market declines?

I get this is a few years old so praying you still are in the community. And thank you or anyone in advance for teaching me something
DMoogle
Posts: 549
Joined: Sat Oct 31, 2020 10:24 pm

Re: How exactly do NTSX and PSLDX get leverage?

Post by DMoogle »

j1mbo wrote: Thu Nov 16, 2023 10:30 amSo breaking it down even more layman's for me - if I buy that 528k in treasury futures, is that purely speculating over interest rate sensitivity? Or with risk free being about 4%, is there a discount to account for the coupon that I won't receive?

Or maybe another wording - does ntsx profit off the treasury future itself? Like market goes up and treasuries stay even, would they capture. 9x market and .6x interest? Or is the treasury future just exist to profit off decreasing interest rates which hedges market declines?

I get this is a few years old so praying you still are in the community. And thank you or anyone in advance for teaching me something
Good questions. It's not pure speculation, but it's kinda close honestly. I think the best way to think about it is that you're short a short-term rate (the implied financing cost of the future), and you're long a long-term rate (the return of the underlying treasury, which the future is priced upon).

Theoretically, when extrapolated and over the long run, short-term rates should be lower than long-term rates. So yes, if that assumption holds and rates are even, then the treasury future should yield a positive return. That said, I would argue that the primary function is for extra diversification (with an added tail-end risk). And yes, the coupon is accounted for in the price.

@skierincolorado might be able to provide better insight. I'm far from a futures expert. I'm not particularly active here anymore, but I do still read most of these conversations on the use of leverage, because I'm using leveraged strategies in my portfolio (mostly following the modified HFEA strategy).
muffins14
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Location: New York

Re: How exactly do NTSX and PSLDX get leverage?

Post by muffins14 »

j1mbo wrote: Thu Nov 16, 2023 10:30 am
DMoogle wrote: Mon Sep 20, 2021 12:17 am Back to basics: a futures contract simply means that you've committed to purchase the asset some time in the future. The 10-year T-note contract is currently worth about $132k. HOWEVER, you don't *actually* need to have $132k in your account to buy the contract. You can have far, far less. This is because the guys that issue the futures know that the 10-year note is fairly stable, very liquid, and the odds of its value dropping dramatically is practically nil. In fact, according to https://www.cmegroup.com/markets/intere ... rgins.html, you only need $1,400 in your account for that $132k contract. Pretty crazy, right? It's fundamentally different from stock in that, with stock, you basically trade cash for your shares. For futures, you don't actually trade cash - you essentially buy the contract for "free," as long as you have some cash in your account in case the value goes down (and you get margin called).

So what would this look like in practice? Say you have $1m in your account and you want 90% equity/60% 10y treasury exposure. You could "buy" 4 10y contracts worth $528k (note no cash is deducted from your account), buy some shares of a treasury ETF for $72k, and then buy a stock ETF for $900k. Boom, 90/60.

On your question about everything crashing - few points to make:
  • Margin calls largely prevent people from losing more than their account's equity. I say "largely," because there have been some documented instances where the margin calls haven't worked properly, and people have reached negative equity in their account.
  • In a crash, there's no reason you wouldn't be able to maintain the 90/60 in one way or another. It just means your equity is lower than it once was.
  • Yes, margin calls are a real risk in a big crash, especially if you're highly leveraged. However, they aren't the devil they're made out to be. If you've lost equity, but you haven't rebalanced, then that means that your leverage has gone up (say if treasuries crashed, then your exposure might have gone up to 90/80, or if everything crashed, then maybe 130/75). Margin call is just a forced rebalance... something that the fund will do on its own normally.
So breaking it down even more layman's for me - if I buy that 528k in treasury futures, is that purely speculating over interest rate sensitivity? Or with risk free being about 4%, is there a discount to account for the coupon that I won't receive?

Or maybe another wording - does ntsx profit off the treasury future itself? Like market goes up and treasuries stay even, would they capture. 9x market and .6x interest? Or is the treasury future just exist to profit off decreasing interest rates which hedges market declines?

I get this is a few years old so praying you still are in the community. And thank you or anyone in advance for teaching me something
You get returns from holding futures.

For example you get the return of the longer-term futures, but you’re effectively paying interest to borrow the money.

When long-term rates are higher than short-term rates, you are earning a term premium while also holding an asset that usually rises in deflation recessions. When the yield curve is inverted, you get zero to negative money because you’re borrowing at a higher rate than you’re earning, but you can interpret that like the cost of insurance, where insurance means “treasuries usually go up in a deflationary recession”. Of course in 2022-2023, holding a huge stack of treasury futures incurred a lot of losses
Crom laughs at your Four Winds
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