Today's topic of conversation is margin rates, that is, the rate your broker charges you on a margin loan. The margin rate can have a profound impact on an investor's overall return and may even be the make-or-break factor in determining whether a given trading strategy will be profitable. 

To illustrate, let's consider the following example: say we have a investment strategy designed to produce average annualized returns of 5%. While 5% may sound meager to some investors, imagine that our strategy is a highly risk controlled one that hedges out most of the risk of overall market fluctuations (this could be a long/short portfolio for example). Therefore, leveraging the strategy up to 4 to 1 is both feasible and prudent. So, without margin (i.e. using leverage) the portfolio produces 5% annualized returns, but at a leverage ratio of 4 to 1, the porftfolio produces returns of 20%. 

Sounds great, no?

Alas, the story is never so simple. The missing piece here is that we need to deduct the cost of the margin loan from the portfolio's return. So, if our margin rate is say, 6%, then we will end up incurring a negative 1% loss for any leverage we take on (since it costs us 6% to make a return of 5%). Obviously, the cost of the margin loan negates the profitability of the trading strategy.

Now this is where it becomes interesting. The most indelible shift during the past 15 years in the brokerage industry has been the emergence of discount brokers, with their constant drive towards lower costs. Generally speaking, the effect this has had on commission structures has been to drive the entire industry towards similar commissions, as well as greater transparency on commission charges. While different discount brokers have different commission schedules, they are all within a competitive range.   

What's surprising is that the same cannot be said about margin rates. There is a huge range of margin rates across different discount brokers as is illustrated in exhibit 1 below.

Exhibit 1 isn't comprehensive by any stretch of the imagination, however, it does illustrate the point. Going back to our trading strategy described earlier, only Interactive Brokers, ETrade and Fidelity charges a margin rate that would make our strategy profitable. Moreover, the strategy with Etrade and Fidelity only becomes profitable if we have an account net equity value of 1.5 million or more.

What's the lesson here? Choose your broker wisely. The margin rate can be just as important (if not more important) than commission rates, execution, technology, or service.

I recently came across a highly insightful 2010 working paper out of the University of Sydney Business School entitled "Portfolio Margining: Strategy vs Risk" by E.G. Coffman, JR & D. Matsypura & V.G. Timkovsky.

The paper explores a number of different ideas including the riskiness of regular Reg-T margin versus Portfolio margin, the impact that the Portfolio Margin Pilot program may have had in terms of contributing to the stock market crash of October 2008, and the authors' belief that strategy-based margin has been unfairly discredited as a result of misinformation about the computational complexity of the strategy-based margining problem combined with the general bias towards heuristics by those (typically of the lawyer mindset) setting strategy-based margin rules.

Here is the abstract for the paper: 

The paper is quite advanced and may not be accessible to the average reader. However, for the technically inclined reader, the paper is definitely worth a read as it contains thought provoking examples of how Portfolio Margin can cause a pyramiding of debt under certain plausible market scenarios. 

So what does this all mean? Admittedly, not that much for the average investor. 
However, this paper and the concepts it contains should be read and mastered by anyone who works in margin and risk control at a brokerage firm. I applaud the authors for their work. 

For your conveniance, I've included a copy of the paper below.

The good folks at www.tastytrade.com have posted an interview with Scott Sheridan, the co-founder of thinkorswim (acquired by TD Ameritrade in 2009). The video discusses Portfolio Margin. I've embedded the video below. 

Informative? Honestly, not really. 
Unfortunately, the video is short on substance and long on ad-hoc commentary. While Scott is clearly articulate and knows his stuff, only the first six minutes of the video is really focused on portfolio margin. That said, I applaud the folks at tastytrade for continuing to produce useful and original videos for the trading community.   

Much has been made in recent years of the so called "buy-write" index (ticker:BXM) and its related ETFs (ticker:PBP). For the layman, a buy-write index ETF encapsulates a covered call writing strategy in a simple, buy and hold product.

The hoopla around this index is not surprising given that it has outperformed the S&P 500 index insofar as risk-adjusted return in concerned. With investors hungry for returns yet also weary from the volatility seen during the 2008/2009 financial crises, the buy-write ETF offers an attractive alternative to a passive long index fund.

Without further ado, let's get straight to the charts. The performance of the buy-write index (the ticker is BXM) versus the S&P 500 index (GSPC) can be seen below. As is evident, the BXM significantly outperforms the S&P 500 over the five year period from 2007 to 2012. 

So now you're interested, right? Let's explore this strategy in more detail.
The first question is: What exactly is a buy-write strategy and the BXM index?
 
The term "buy-write" was coined by the CBOE (which was one of the first companies to compile an index reflecting the returns of a covered call index strategy). The premise is simple - The CBOE's BXM index represents a strategy that: 

In other words, the BXM is just a continuously managed covered call strategy written against the S&P 500 index.

The key advantage of a buy-write strategy is the superior risk/return profile. The idea of "better risk adjusted returns" isn't hollow rhetoric. There is plenty of justification to be found in a growing body of literature examining the strategy's characteristics. In one of the more comprehensive studies to date, Kapadia and Szado (in a September 2011 paper "15 Years of the Russell 2000 Buy‐Write") show that a strategy of selling out-of-the-money covered call options on the Russell 2000 produces higher returns than a simple Russell 2000 position. Further, the buy-write strategy comes with about a third less overall volatility than the pure long Russell 2000 strategy. 

The results of the Kapadia et al (2011) study, combined with other similar studies can be used to substantiate the following claim. As a general rule of thumb, a buy-write strategy should produce returns similar to (or slightly less than) the S&P 500 index, but with about 50% to 70% of the volatility

The final major advantage of the buy-write index (and the primary reason I'm blogging about it) is that it qualifies for Portfolio Margin treatment. In particular, it's falls within the High-Capitalization Broad Based Indexes Group, which means that the stress test range applied is: -8% to 6%. With such a small market move being applied to determine the margin requirement, taking a leveraged position in PBP is extraordinarily easy. By leveraging up to say, 1.3 to 1 , the fund will have about the same volatility as an S&P 500 fund (ticker:SPY), but with a much higher return expectation. 

The key point of all this is that a buy-write ETF in a margin account can provide more bang for the buck than your traditional S&P 500 ETF. As modern portfolio theory teaches us, smart investors should always seek out higher risk-adjusted return investments and simply leverage up to a level of risk commensurate with their own unique risk appetite.

Jesse Drucker of Bloomberg recently published an article (see Buffett-Ducking Billionaires Avoid Reporting Cash Gains to IRS) discussing the growing list of billionaires caught in the IRS's increasingly more dim view of prepaid variable forwards (PVF).  

PVF's have become the "go-to" tax strategy for high net worth individuals seeking to monetize unrealized capital gains on publicly traded stock without actually triggering a taxable event. The PVF is simply a forward contract where the owner of the stock agrees to sell a variable number of shares to the counterparty at a fixed time in the future. The number of shares varies with the price of the security such that the total value of the sale is within a fixed range (the range is usually around 15% so that the IRS's constructive sale rule can be avoided). The PVF contract is packaged with an up-front loan from the securities buyer to the securities seller. The economic essence of the PVF transaction is that the securities seller gets paid up front (via the loan) but doesn't deliver the securities until some point in the future.

To fully grasp the attractiveness of the PVF it's important to understand two key assumptions:

1. Since the PVF is a single contract and title to the securities isn't transferred until the future, the IRS does not consider this a capital gain until the forward delivery date. Thus, capital gains taxes can be postponed.

2. From a securities regulatory standpoint, the PVF is viewed as a stock sale (i.e. not a loan) and therefore not subject to Federal Reserve Reg-T. This is a major advantage since the full proceeds of the loan can be used for any purposes. Basically, this is an end-run around Reg-T's 50% margin requirement.