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!
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.
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.
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.
- 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.
- 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).
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.