Aurora Borealis
1 January 1990 Financial Analysts Journal Volume 46, Issue 1

Calendar Spreads for Enhanced Index Fund Returns

  1. Jesse Wolf

It is well known that an equity index fund manager can enhance returns by selling the index stocks, investing the proceeds in a money market instrument and simultaneously purchasing “cheap” stock index futures contracts. More specifically, the manager with a “distant” investment horizon may swap the index stocks for “far” expiration futures contracts and Treasury bills of identical maturity. This simple strategy assures receipt of a given bill yield over the horizon and enhancement equal to the underpricing of the futures contracts relative to the contracts’ fair value with respect to that yield.

An alternative, slightly more complicated, procedure offers enhancement through a series of transactions that may be seen as a swap of index stocks into far futures contracts and a synthetic/actual money market instrument. With this procedure, a manager with a long stock index position sells futures contracts with a near expiration date and buys contracts with a more distant (far) expiration date. He also purchases a money market instrument for delivery at the near-contract expiration and maturity at the far-contract expiration.

By holding the stocks until the near expiration and selling the near contract at the outset, the manager constructs synthetic cash through the near expiration. The proceeds of this synthetic investment (receipts from the near-contract sale plus dividends received on the stock) are rolled over into the actual money market vehicle at the near expiration, thus creating a money market instrument that is initially synthetic and subsequently actual from today through the far expiration. Meanwhile, through purchase of the far contract, the manager retains equity market exposure throughout.

This series of transactions essentially allows the manager to “lock in” at the outset an incremental, known return over the long stock index position. Furthermore, to the extent the yield on the synthetic/actual money market instrument surpasses the yield on the far T-bill, this strategy will provide incremental pickup relative to the simple enhanced index trade.

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