In the last week of 2022, Alpha Architect launched the BOXX etf. Depending on your needs, it is a promising alternative to T-bills – but the thing that’s so cool — BOXX is doing the same trades option traders do to manage their cash!
Background
In the summer of 2022, I watched an episode of Show Us Your Portfolio, where professional investors discuss how they personally invest. This episode featured Wes Gray the founder of Alpha Architect.
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How I Invest My Own Money: Robust to Chaos (blog post)
After appearing on the show Wes actually wrote out an in-depth blog post explaining how and why he invests the way he does. Notice the thoughtful appreciation of his constraints and goals, then see how he matches them with a portfolio.
I’ve gotten to know Wes over the years and found his framework deeply resonant with my own thinking. I called him to discuss certain aspects of it in more detail.
While discussing the portfolio, he told me about the upcoming BOXX ETF knowing I’d geek out on the options bit. Not to mention that the ETF is sub-advised by former colleagues from my SIG days.
Now that the ETF has been on the market for 9 months and garnered a critical mass of assets (>$400mm AUM), I feel comfortable explaining how it works. Before I get to that let’s discuss the value proposition to investors.
Features
The attraction here is straightforward, tax-efficient cash management:
You will understand why it’s t-bill risk and t-bill return without actually holding t-bills when we walk through the mechanics of its trade. But the thing that should pop out at you is:
You can get this type of product in an exchange-traded format –an ETF. So you don’t pay taxes until you sell (unlike mutual funds), you can hold the ETF in a vanilla brokerage account or tax-advantaged account like an IRA or 401k (if your plan allows it). You could even use it as one of the components in an automated ETF rebalancing program like you can build with Composer.
I’m going to pause here because I don’t want to rehash research that is already well-done. Nomadic Samuel wrote a great explainer of the ETF:
BOXX ETF: Review Of The Strategy Behind Alpha Architect 1-3 Month Box ETF (Picture Perfect Portfolios)
There’s a section of the explainer I want to zoom in on:
Well, the Moontower reader is gonna understand how this thing works in a moment. A “box” trade is covered on day 1 for option brokers and trading trainees.
How Box Trades Work
Before my additions, I’ll point you to Wes’ in-depth explanation of box spreads:
Box Spreads: An Alternative to Treasury Bills? (Alpha Architect)
This is a great option explainer. He walks through it just like I would.
- Shows that buying a call and selling a put on the same strike is a synthetic future position. Just think of it this way…if you buy a 100-strike call and sell a 100-strike put in the same expiry month, then at expiration, no matter what happens, you will buy the stock for $100!
Why?
- If the stock is above $100, you exercise the call
- If the stock is below $100, you get assigned on the put
- If you buy the synthetic future with a $100 strike and short the synthetic future with the $110 strike you will make $10 at expiration with certainty, you have locked in $10 at expiration. Of course, the cost of such a payoff today is not zero…that would be free money.
The cost of a riskless $10 in say 1 month’s time is just the present value of $10.Think of a t-bill. A t-bill is just a zero coupon bond that says at maturity you receive $10. You might pay $9.95 for that today. You will make $.05 profit guaranteed for outlaying $9.95 today.
This implies a yield or T-bill rate of .05/9.9 = .5% (or an annualized 6%)
A box is the simultaneous buy and sell of synthetic futures for the same expiration date with different strikes. The difference between the strikes is like the face value of zero-coupon bond.The premium you pay for that expiration payoff implies the yield to maturity, the same way the price you pay for a T-bill implies the rate you receive.
Wes’s more detailed explanation with my highlights:
Wes reiterates the entire basis of Law of One Price which stipulates that 2 instruments with the same cash flows will offer the same return in present value terms.
My old professor, Dr. Eugene Fama, is sure markets are efficient. And if two assets earn a similar return, it must be the case that the risk of these two assets is very similar. And now that we’ve determined that box spreads earn similar returns to treasury bills (often higher!)
“Often higher?”
Wes drops a hint — the box rates are often higher than the t-bill rates.
This isn’t crypto land where you can just say anything you want. Wes is operating in a highly regulated SEC compliance environment. You don’t overpromise. And he doesn’t need to — if box rates and t-bill rates lined up perfectly the value proposition of the ETF still shines through.
But this is where my experience can add some color. I’m not surprised the box rates are higher.
“Kris, why would the box rates be higher?”
When you study options pricing and Black Scholes you learn that the risk-free rate is used to discount the payoffs to present value. In practice, options market makers don’t just deal with a single rate. There are at least 4 rates that matter:
- Stock long rate: the cost to finance long shares
- Stock short rate: the interest you receive on the cash raised by a short sale. Sometimes referred to as the “rebate”. In hard-to-borrow stocks you often pay interest to be short!
- Option long rate: The cost to finance option premium that you’ve outlayed
- Option short rate: The interest received on debit option balances
The clearing firms that custody and finance trading accounts are for-profit businesses — they earn a spread on the long rate vs the short rate. Same as banks.
In general:
- the cost to borrow money is going to be the SOFR rate + the clearing firm’s margin
- the interest received on cash balances is the T-bill rate – the clearing firm’s margin
SOFR rates are derived from overnight loans collateralized by Treasuries, therefore they trade very tight to t-bill rates. The bulk of the financing spread is simply the clearing firm’s margin.
If t-bill rates are 6% and the clearing firm’s margin is 50 bps per side, then the clearing firm is willing to lend to the trader at 6.5% and pay 5.5% on cash balances.
The key insight: Market makers cannot freely borrow and lend at a single risk-free rate as theory assumes
At any given time there is likely some market maker that is cash-heavy and earning say 5.5% while another is paying 6.5% to finance long share or option positions. The box market is a way for them to increase or decrease their cash balances! If you are long lots of option premium and paying 6.5%, you can sell a box spread which allows you to lay off premium in exchange for cash. You might sell that $10 box for $9.95 effectively borrowing cash knowing at expiration you will owe $10.
This is smart — you are refinancing your position from paying 6.5% to the clearing firm to borrowing from the options market for 6%!
The point is that there is no real voodoo here — boxes allow market makers to re-finance their positions with each other effectively cutting out the banks.
If the rate prevailing in boxes is typically higher than the t-bill rate that tells you that the options world is a net owner of shares/option premium because the box rate is clearing at a slightly higher rate than t-bills imply.
I have mentioned that so much of options trading is not fancy ideas but mundane business considerations. Like keeping your financing under control. Boxes and their siblings, reversal/conversions, have active liquid markets. There are brokers who deal in them all day. At a large enough options shop, there is a trader who deals in them all day. It’s analogous to the treasury department at a bank, charged with minimizing funding costs.
The BOXX ETF is a legitimate innovation allowing non-option investors to buy box spreads. This allows them to lend at box rates. To supply liquidity to the options market which is a net borrower.
Caveats
- Funding spreads aren’t necessarily 50 bps per side. It depends on the client’s riskiness and how big an account they are. When I had a small private backer the funding spread was multiples of the funding spread I had at SIG or the hedge fund. The wider your funding spreads, the more inclined you are to trade box spreads so you can tap into the market rate and cut out the clearing firm’s margin.
- Your counterparty in box trades is the exchange clearing house. These are very strong credits. You face that risk any time you trade options. Wes addresses that in his article.
- BOXX holds European-style options so there is no early exercise risk.
- BOXX is tax efficient. In fact, it can be more efficient than owning state-tax-exempt t-bills but this is something for you to work through with an advisor. It depends on your specific situation.
- In general, derivatives markets, governed by the invisible hand of intense arbitrage pressures embeds funding rate very close to Fed Funds (ie short term t-bills) rates. When you buy an SP500 futures contract you are getting leveraged exposure since you only need to post cash margin at a fraction of the full notional value. This inherently levered position means you are borrowing. However, it is the most cost-effective form of borrowing because the rate is inherited from arbitrage by the most well-capitalized traders who can afford to lock in risk-free profits with the smallest possible margins. The team at Return Stacked Portfolio Solutions wrote a simple explainer post reviewing the mechanics — The Cost of Leverage
Extra for Option Masochists
It’s hard to overstate just how deeply tied funding concerns are to vol trading.
If my stock long rate is much higher than yours then calls will have a lower implied vol to me than to you. Likewise puts will look more expensive than you. If I had a long stock position I’d want to swap it for a long synthetic futures position by doing a “reversal” (buy call, sell put, sell stock). If my rate was much lower than the market I’d want to “convert” (sell call, buy put, buy stock).
See You Think You’re Trading Vol…But Are You Even?
Every option trader has used revcon.xls to price the exact carry on a position down to the T+1 settlements for options and T+2 for stock. They’d be counting days like fixed income traders.
Box spreads are the simplest arbitrage identities in the options market. They are the basis of figuring out what a put spread is worth by knowing the call spread value.
BOXX is a really neat product allowing equity investors to tap into the borrow/lend markets that were once fenced off to option participants. And the option participants are happy because an already deep market is getting deeper.