Elaborating on the Global Rydex Idea

I had a few different people ask for clarification on the Global Rydex idea I posted. I debated whether to even include the idea in the list originally, because it’s an esoteric topic that may be confusing to people not familiar with the myriad financial instruments available today. I realized halfway through an explanation I was writing that it’s better to just make it an entirely new post.

 

How Rydex works

Rydex has an investment platform that enables you to trade between a collection of Rydex-managed mutual funds. You can trade twice per day, once at the open and once at the close, but most people trade at the close 1.

While Rydex offers an entire suite of funds, the largest funds are the S&P 500 2x and the Inverse S&P 500 2x. These funds aim to return twice the cash close of the S&P 500 and twice the inverse of the close, respectively. For instance, if the S&P 500 Index is up 1% at the end of the day, the former fund would be roughly +2% and the latter would be -2%. Rydex charges you a fixed percentage (~1.69% annualized) on any money in either fund.

Now, the standard approach to developing a daily trading model is to download OHLC data from a source like Bloomberg or Yahoo! Finance. For instance, you can download the S&P 500 data and come up with some predictive model for that time series. To make money off that model, you would need a way to trade the S&P 500 Index.

You can go long/short all the stocks in the S&P 500 via an ETF. This is great, but if your model trades frequently, your trading costs will begin to increase. Also, if you’re trading relatively small amounts at first and your model takes fractional positions, you may find that the cost of one ETF does not give your model sufficient granularity in position sizes. Finally, you also have to do the trading yourself, meaning you have to actually put a bid/offer in and pay the spread. All of this would be what is known as “slippage”– the amount your actual average costs will differ from the cash close price. If your slippage is large, then your model backtesting is inaccurate.

Enter Rydex. Rydex enables you to move any fractional amount around (to the nearest $0.01) between the 2x long, 2x short, and money market funds without any trading fee. Not only that, but because Rydex the 2x long and 2x short positions are simple inverses of each other, they only have to purchase/sell enough futures contracts to cover the net difference between the two funds, but they can spread the slippage over the entire amount. For instance, if they have $450M in the 2x long fund and $400M in the 2x short fund, they only need to purchase $50M in S&P 500 futures. They will still have some slippage on this $50M, but the other $800M will effectively have no slippage and thus the overall funds track very closely to their benchmarks.

 

So where does my idea come into play?

Well, the S&P 500 is not the only index out there. In fact, every major market has an index with a relatively liquid futures contract (not nearly as liquid as the S&P 500 e-mini futures, but liquid enough). Rydex offers some funds for foreign indexes like the Nikkei 225, but unfortunately they assume you want to trade the Nikkei at the same time as the S&P 500 (4PM EST). However, if you download OHLC data for ^N225 on Yahoo! Finance, you’ll notice that the prices are based on the Osaka exchange.

Thus, if you want to backtest your models on cash data like most people do, you have no option for trading those models with real money except to actually buy/sell futures contracts yourself. This is an expensive option to say the least, since a single Nikkei 225 mini futures contract I believe is around $10,000. Thus, to get sufficiently granular fractional positions, you would need at least $200k or so just to trade the Nikkei. There are easily a dozen other indexes with similar issues here.

 

Conclusion

A Global Rydex would enable the smaller-scale registered investment advisory (RIA) to provide their clients with the benefits offered by global diversity. Given the potential size of these funds, I think it’s clear that if someone set it up, you could be looking at a few billion AUM in a matter of a year or so.2

 

Footnotes

  1. For some background here, about 10% of the entire volume of the day is traded in the 10 minutes around the close of the cash market. This is true for both futures and stocks. Thus, it’s a very liquid market during the close.
  2. For context, Rydex has over $25B under management.

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