In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years.
This is a really interesting and counterintuitive idea, that I really like, but after thinking about it a lot, decided probably does not work. Here’s my argument. For simplicity let’s assume that I know for sure I’m going to die in 30 years[1] and I’m planning to donate my investment to a tax-exempt org at that point, and ignore dividends[2]. First, the reason I’m able to get a better expected return buying stocks instead of a 30-year government bond is that the market is compensating me for the risk that stocks will be worth less than the 30-year government bond at the end of 30 years. If that happens, I’m left with 0.3x more losses by buying 1.3x futures instead of 1x stock, but the tax offset I incurred is worth nothing because they go away when I die so they don’t compensate me for the extra losses. (I don’t think there’s a way to transfer them to another person or entity?) So (compared to leveraged buy-and-hold) the futures strategy gives you equal gains if stocks do better than risk free return, but is 0.3x worse if stocks do worse than risk free return. Therefore leveraged buy-and-hold does seem to represent a significant free lunch (ultimately coming out of government pockets) compared to futures.
ETA: The situation is actually worse than this because there’s a significant risk that during the 30 years the market first rises and then falls, so I end up paying taxes on capital gains during the rise, that later become taxable losses that become worthless when I die.
ETA2: To summarize/restate this in a perhaps more intuitive way, comparing 1x stocks with 1x futures, over the whole investment period stocks give you .3x more upside potential and the same or lower downside risk.
[1] Are you perhaps assuming that you’ll almost certainly live much longer than that?
[2] Re: dividends, my understanding is that equity futures are a pure bet on stock prices and ignore dividends, but buying ETFs obviously does give you dividends, so (aside from taxes) equity futures actually represent a different risk/return profile compared to buying index ETFs. I’m not sure how to think about this, e.g., can we still treat SPY and SPX futures as nearly identical (aside from taxes), and which is a better idea overall if we do take both dividends and taxes into account?
This is a really interesting and counterintuitive idea, that I really like, but after thinking about it a lot, decided probably does not work. Here’s my argument. For simplicity let’s assume that I know for sure I’m going to die in 30 years[1] and I’m planning to donate my investment to a tax-exempt org at that point, and ignore dividends[2]. First, the reason I’m able to get a better expected return buying stocks instead of a 30-year government bond is that the market is compensating me for the risk that stocks will be worth less than the 30-year government bond at the end of 30 years. If that happens, I’m left with 0.3x more losses by buying 1.3x futures instead of 1x stock, but the tax offset I incurred is worth nothing because they go away when I die so they don’t compensate me for the extra losses. (I don’t think there’s a way to transfer them to another person or entity?) So (compared to leveraged buy-and-hold) the futures strategy gives you equal gains if stocks do better than risk free return, but is 0.3x worse if stocks do worse than risk free return. Therefore leveraged buy-and-hold does seem to represent a significant free lunch (ultimately coming out of government pockets) compared to futures.
ETA: The situation is actually worse than this because there’s a significant risk that during the 30 years the market first rises and then falls, so I end up paying taxes on capital gains during the rise, that later become taxable losses that become worthless when I die.
ETA2: To summarize/restate this in a perhaps more intuitive way, comparing 1x stocks with 1x futures, over the whole investment period stocks give you .3x more upside potential and the same or lower downside risk.
[1] Are you perhaps assuming that you’ll almost certainly live much longer than that?
[2] Re: dividends, my understanding is that equity futures are a pure bet on stock prices and ignore dividends, but buying ETFs obviously does give you dividends, so (aside from taxes) equity futures actually represent a different risk/return profile compared to buying index ETFs. I’m not sure how to think about this, e.g., can we still treat SPY and SPX futures as nearly identical (aside from taxes), and which is a better idea overall if we do take both dividends and taxes into account?