Indexing with Synthetics and Futures

This chapter constructs a relatively low‐risk leveraged portfolio using both synthetic positions and futures contracts. The portfolio has average long‐term returns exceeding 15.6 percent before transaction costs and is only a little more risky than an average index fund. It is necessary to make certain assumptions about the underlying fund's return and risk based upon both recent returns and long‐term historic averages. The greatest change was raising the expected volatility to reflect long‐term historical averages. The portfolio is capable of a very wide range of returns and a single standard deviation is quite high. This creates a “lottery ticket” effect where a few leveraged investments can generate extremely high returns that help pay for the losses in other investments, and explains why the mean ending equity is generally higher than the median. Depending upon the investment structure used and the margin requirements, margin calls are possible but statistically unlikely for this portfolio. The likelihood of a margin call can be recalculated periodically using the current leverage ratio, the maximum leverage ratio, the average rate of return, and the overall volatility.