January 27, 2008

Stock Pair: Short XLF Long BofA

The strategy:

Long BofA shares and short the XLF (financial index ETF) to pocket the dividend difference between the two assets ( Dividend yield differential: 3.51%).

Strategy Rationale:

  • The strategy is to exploit dividend yield differentials and it is slightly bullish on BofA.
  • The two assets are highly correlated at .7, which means a high degree of similar return movement over time, XLF has a 70% probability of positive return if BofA has a positive return and vice versa. The pair most of the time will likely yield a zero sum profit/ loss relationship.
  • With the strategy you can avoid the uncertainties in the banking sector by maintaining this hedge.
  • BofA composes 9% of the index, so a big chunk of XLF's returns are generated and explained by BofA stock movements.
  • BofA has a 6.5% dividend yield while the XLF has a 2.99% yield. The difference in yield can be the return on this hedged strategy of 3.51%, which is a bit higher than your T-bill rate.
  • BofA is fundamentally stronger and has upside potential, in my view, in comparison to other financial holdings of the index.
  • The average return for BoA is .005 over 109 monthly observation, while XLF has an average return of .002. so the strategy has a probability to achieve upside potential of higher returns on BofA compared to XLF.
  • The strategy does not require any capital except for your broker margin requirements.

Strategy Risk:

  • Company specific risk. In other words if BofA fundamentals deteriorate or decides to cut dividends the strategy can be a loser and should be closed immediately.
  • Historical relationship may not hold into the future. The stock market is notorious in destroying historical statistical relationship, just ask the principals of Long Term Capital Management.
  • Your liquidity risk. The relationship can hold over time but that does not mean that it will hold each single day. Some days you will be under due to daily price movements and BofA specific announcements. So your ability to maintain your short is critical, if your broker calls you to cover the margin. Do not undertake the strategy if you can't provide additional margin.
  • If you think this is like "picking nickels in front of a bulldozer" then obviously the rewards do not justify the risk. But if you believe in the statistical relationship between the two assets and it will continue to hold then you have a nice return for almost no capital.

Your input on the strategy is greatly appreciated!

3 comments:

Richard said...
This comment has been removed by the author.
Anonymous said...

Why not put your $$ in a MMA IRA? It's virtually risk-free and you get about the same yield or higher with banks that pay out a higher rate. No need to deal with liquidity issues, transaction costs, etc.

Sami said...

because there is an upside potential with owning a security. Although in this environment it does not seem there is much upside :)