Web hosting Custom Email SiteBuilder

WARNING : Be aware that if you are tempted to follow a similar investment approach to the method described here, in backing the FT100 to the tune of £10 per point, then the effective maximum downside is £10 for every point the index might fall. So if the index was 6500 and fell to 0 (albeit very unlikely to actually go to zero), then your loss would be £65,000. If you're looking to mimic this approach for yourself, then ensure that you are totally familiar with the potential risks involved.

The method we prefer to track an Index is to buy the index itself. So doing avoids the need to proportion individual share purchases in an attempt to mirror the Indexes constitutes and weightings.

The easiest method to buy the Index is to use one of the Financial Spread Betting Services.

Our DIY Index Tracking approach works fundamentally because, whilst the Financial Spread Betting Broker charges a premium against a Future Index contract quotation (e.g. quoting maybe 6600 against the FT100 Index when it currently stands at 6400), that premium is based on :
 
 

Current Index Value + interest on effective loan – dividend yield on effective loan.
 
 

The effective loan is the per point stake level * the index value (e.g. £65,000 if £10 per point stake level is used when the index is 6500). The interest charged against this is usually the base rate interest level (currently 6%) proportioned for the time period of the Future contract (e.g. around 3% if a 6 month contract). If an amount equal to the effective loan is deposited in a bank for a similar duration to the contract period would enable us to effectively cancel such premiums charges (interest obtained from bank covers the effective interest charged by the Spread Betting Broker).

So effectively the real quote to us may be considered as :
 
 

Current Index – dividend yield benefit on effective loan.
 
 

(e.g. the current FT100 dividend yield is around 2% p.a. so on a 6 month contract period, the real value would be around 1% under the current index value).

So in real terms, we’re buying the index at a value that is discounted by the current dividend yield – so we get the dividend yield benefit too!

Now wherever the index goes, we will either profit, if it rises, to the tune of £10 for every point it rises, or loose, if the index falls, by £10 for every point it falls. We have a direct index tracker!
 
 

External Sites about geared Index Tracking

http://www.forbes.com/Forbes/97/1103/6010380a.htm

http://www.peerfinancial.com/saver.html

http://www.clarku.edu/~jgolec/11pimcofund.html

http://www.netisa.co.uk/news/dt19july97.htm

 http://www.aibgovett.com/BODY/PRODSERV/UK/17.htm

 http://businessweek.com/1998/52/b3610063.htm
 
 

Gearing

Instead of banking an amount equal to the effective loan and using the interest received from that to offset the interest premium against the FSBS bet, what about if we invest that amount into an alternative area that provides better returns than a bank deposit. The overall effect would be that we would have more interest coming in than going out and enabling us to achieve better returns than the index overall (or less losses).

So which shares should be selected? Well why not use another index tracker instead! (Alternatives could be to use Managed Funds etc).

One problem with this is that it increases our volatility, that is if the Index doesn't perform well, then we not only loose out on the main Index Tracker, but we might also not recoup sufficient returns to cover the interest charges against the FSBS bet.

To reduce the volatility, we can split this second Index Tracker so as to invest 50% in cash and 50% into the index tracker. From such returns of around mid way between that received by cash based investments and the returns/losses evident against the index will result.

To re-cap:

Having replaced the cash based investment that covered the interest charges against a FSBS bet with the above, we now also take out a £10 per point buy contract against that Index (The main Index Tracker). The gains from the previous position (50:50 cash/index tracker) should generally cover (or better) the premium charge (base rate) required to run that contract.

Overall we effectively have an amount equal to 10 times the current Index banked in a cash based investment area, and a FT100 Buy contract for £15 per point. As the likes of IGIndex accept bets down to £10 per point, we could scale this down so as to have 2/3^rd * 10 * Index value in the bank and a £10 per point buy position (currently with the Index at around 6500 this equates to around £43,333 in the bank and a £10/point bet.

That’s it! Providing the Index (including dividends) generally outperforms the base lending interest rate, then we will outperform the Index. Historically this would appear to be the case as generally investing in the stock market has beaten all other classes of investment over the long term. In fact, the long term growth rate of the UK stock market over the last 80 years is 12.2% per annum or 8.0% per annum if you take off inflation (Source: Barclays Capital Equity Gilt Study http://www.barcap.com/cgi-bin/pressreleases/public/newsView.pl?item=1999020301) compared to cash based investment returning 1.5% per annum (after inflation).

It is important to realise that gains will not pile onto the value of your investment smoothly year on year. Some years, there will actually be a loss, and other years far greater gains, for that is how the market travels and in buying an index tracker the investor ties his/her fortunes intimately to the short-term ups and downs of the market.

As with any stock market investment, you shouldn’t consider investing for anything less than five years or more. If you think you might need this money in the next two years then don't put it in an index tracker and, in fact, don't put it anywhere near the stock market.

Be aware that gearing in this fashion does increase your downside risks. Being effectively geared, a fall in the Index from its present 6500 down to around 2000 would result in us totally losing all of our investment (e.g. a fall in index value by 60-70% fall could wipe us out). Don’t believe that such a fall could never happen? Just take a look at the Nikkei's history!

As an example of the long term view that should be taken when investing into the Stock Market, consider the New York Stock Exchange Index. In January 1996 the NYSE Index stood at around 50.44, ten years later and the Index had fallen by around 5.5% from that 1966 value (sustained bear period). Presently however, that same Index is around the 650 mark. So overall, by following that index through thick and thin, a straight index tracker would have seen average returns of around 12-13% p.a. (including dividends). In contrast, our geared tracker would have shown returns of around 14-15%. When you consider that our returns are effectively tax paid and outperform cash based investments, this should give some indication of the long term possibilities of the method. Notice however that someone starting such a tracker in 1966 and having seen year on year losses over the first ten years would have required considerable faith in order to maintain such a strategy.
 
 

So what might be expect as a return from using this approach? Well if our main index tracker has its premium charges covered by another cash:tracker based position, and that cash:tracker returns profits(/losses) around mid way between the current base interest rate and the Indexes performance, then our main tracker will out/under perform the Index by

Similarly if the Index fell by 14%, but paid a 2% dividend and base rates were 6%, then our main Index Tracker could be expected to under-perform the Index by around

So why not compound this arrangement several times, e.g. a tracker serving a tracker serving a tracker etc? Well a one and a half times gearing is about the most you should consider, otherwise you will be increasingly volatile to adverse market movements. With current interest rates at 6% and dividends at 2% against the FT100, and as you can get 6% interest against cash quite easily, then a 1.5 times geared approach will incur around 9% interest for the FSBS position whilst recovering 6% from your cash based deposit and a further 3% in dividends (1.5 times geared at 2%) which is 9%. You've effectively got a balance such that the dividends and your cash deposit will cover all interest charges against that 1.5 times geared position.  So even if the index didn't move at all, then your profit/loss would effectively be zero. For higher geared arrangements, say 3 times geared, would cost 18% in interest with 6% + (3 * 2%) = 12% recovery of interest charges, a 6% shortfall, the Index would therefore have to rise by at least 2% in order to cover such. Also if the index were to fall by 30%, your losses would be considerable. By limiting the gearing to 1.5 times, the downside risks are that a total loss situation would arise if the Index fell by around 65%, that is the current Index of around 6500 falling to around 2200. The prospects of such a large fall are, in our opinion, quite remote.

If, as plenty of evidence currently indicate, you believe that over the longer term, shares (equities) will outperform other forms of investments and the returns from equities will outperform the base interest rate, then the above described 1.5 geared Index Tracker WILL outperform the Index over the longer term, net of all costs. Considering that whilst some professionally managed funds may outperform the Index only for limited periods (generally the ones who are currently advertising), whilst the majority under-perform the Index, having the ability to outperform the Index over the longer term makes this concept of 1.5 gearing generally a valuable investment tool.

Further local readings :-
     Leveraging
     Historical examples over good/bad periods
     Practical Considerations
     Alternative Investment Strategy - Hedge