Spreads on Spreadbets - the Hidden Cash Muncher

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To set the scene I just need to do a quick refresher on the way I use Spreadbets in order to gain Leverage and boost my Returns. In essence, the Theory is that I ‘mirror’ my Normal Trading ISA Portfolio in the form of Spreadbets and this should give more “Bang for my Buck“.

Probably the easiest way to illustrate it is by using a simple example. Let’s say I have £100k in my ISA which is composed of various Share Positions. I then ‘mirror’ this ISA using Spreadbets to get pretty much the same Exposure to each of the Shares so that the total Spreadbet Exposure is also £100k.

Now let’s say the Normal Shares Portfolio in my ISA goes up 10% in a year - so there is a £10k gain. Everything being equal, the Spreadbet Portfolio should also rise by 10% and £10k but we need to appreciate that there is an Interest Charge on the Money used so we can for theoretical needs in our example say that the Return on the Spreadbet Portfolio EXPOSURE would be probably 7% rather than 10% (the Finance Charge is something like LIBOR plus 2% or so), so the monetary Return is £7k.

But where it gets interesting is that for the Normal Shares ISA I needed £100k to make £10k but with the Spreadbets, due to Leverage, I will have made the £7k from perhaps as little as £30k - so the actual Return on the Capital Invested in the Spreadbet Account is 23% (much higher than the 10% on the Shares or the 7% on the Spreadbet EXPOSURE).

I hope that makes sense, for more details please read the Blogs below - this is Part 7 in the series but if you scroll to the bottom of it there are links to the other Parts (be warned, there is a lot here but if you are serious about Spreadbetting or using other forms of Leverage then this might be a worthwhile read, and that is especially the case if you have never used Spreadbets before and are considering using them):

http://wheeliedealer.weebly.com/blog/how-to-use-leverage-safely-and-successfully-spreadbetting-and-cfds-part-7-of-7

The Catch
Well, the text above should explain the theory of how I use Spreadbets and give some idea of how the Returns from ‘mirroring’ work in practice, however, in The Real World (remember, WD is obsessed with “Investing in the Real World” - the few of you who have seen my Business Cards will have seen this emblazoned on some of them) where I am using this mirroring technique Day in, Day out, I am finding that it doesn’t quite work as neatly as I would like.

I am pretty sure that in my ‘Scores on the Doors’ Blogs for the last 3 years I have mentioned this issue I am finding with how I use the Spreadbets - and I lament in each of those Blogs about how it frustrates me that I am not quite achieving the Returns on my mirrored Spreadbet Portfolio that I think I should be getting.

There are some reasons for a discrepancy from the Theoretical ‘10% and 7%’ kind of thing that are acceptable and legitimate, such as the following:

• My mirroring from the Trading ISA (see my ‘Portfolios’ page for more details on the different Portfolios I run) is not in any way perfect - for instance, I tend to have smaller Position Sizes for Small Stocks when I replicate them as Spreadbets - for example, I might have, say, £5000 in Safestyle SFE as normal Shares but only have £3000 when mirrored as Spreadbets - such discrepancies might appear small, but in practice I think they are making quite a difference to the overall Returns.
• Similar to the point above, for some Shares, one example is Moss Brothers MOSB, when I bought them in the first place, igIndex were not offering the Stock as a Spreadbet - so I was forced to overweight my Normal Shares Position in MOSB but I had none in the Spreadbet Portfolio - this obviously is a major difference.
• You may have noticed that I run my Normal Trading ISA which is the main home of my dosh (and this is the Portfolio which I report on after the Close each day on Twitter and which is the subject of my ‘Weekly Performance’ updates which appear on the Homepage usually at the start of the week) but that I also run a small ‘Income Portfolio’ which I have only been running for about 4 years which has just 12 Boring Stocks in it with a focus on generating Dividends (look on my ‘Portfolios’ page and this might make more sense). Just to complicate my ‘mirroring’ as well as having Spreadbets on most of the Normal Shares in my Trading ISA, I often have Spreadbets on the Shares in my Income Portfolio. Note I said “often” - this is because I tend to trade Ranges which the Income Portfolio Stocks move in using Spreadbets from time to time - always on the Long Side. The Stocks in the Income Portfolio are ‘Hold Forever’ kind of plays and I rarely Sell any of them - but I use the Spreadbet Trades on them just to juice up Returns a bit. However, in terms of my problemette with regards to my ‘mirroring’ being far from perfect, these Trades are skewing the Returns to some extent - and this is something I accept and am prepared to put up with and if anything they are flattering the Returns from my Spreadbet Account.
• Another factor is that I tend to have heavier Weightings to larger Stocks in my Spreadbet Account due to the Risks involved - so compared to my Normal Shares Trading ISA, the Spreadbet Account might have higher Weighting to FTSE100 Stocks and lower Weightings to the FTSE250 and Smaller Stocks - the latter tend to outperform so this would also drag on the Returns in the Spreadbet Account. To exaggerate this effect, there are a couple of Stocks like Aggreko AGK and Standard Chartered STAN which I only hold as Spreadbets - so this obviously has an impact on how well the ‘mirroring’ works in practice.
• Also in my Spreadbet Account I do occasional ‘Hedging’ Trades where I short Indexes and these have an impact on the Returns on the Spreadbet Account - and last year they had a really nasty impact but I won’t re-live that horrible experience here !! In addition, I sometimes do opportunistic Long Trades on the Indexes and these also will have an impact on the Overall Returns of my Spreadbet Account.

So as you can see, the Theoretical ‘10% and 7%’ Returns from mirroring that I talked about earlier are in fact very unlikely to be replicated exactly because I do so many things that are obviously destroying that simple equation. However, I think there is more to it than that and I am constantly thinking about what is going on and how my Returns are being gobbled away by something I am doing - and what I can do to fix it.

Just to add a little more colour and to give an insight into why this is bothering me at the moment, at the time of scribbling the First Draft of this Blog, my Normal Trading ISA is up about 15% over 2017 so far but the Return on Exposure in my Spreadbet Account is only running at about 7.5% - so as you can see it is massively underperforming where I think it should be. If my Spreadbet Account was now at about 10% Return on the Exposure I would be more relaxed but as things stand it looks like something is eroding my Returns (Just for completeness, the Return on Capital Used in my Spreadbet Account is running at about 22% which is clearly a lot more like it and shows the effect of Leverage !!)

A Possible Culprit
I am pretty sure I have figured out one simple thing that is eating away at my Returns and there are some possible changes I can make to how I do things that should help reduce the negative impact.

Some years ago I used to use CFDs (Contracts For Difference) with City Index (I actually have an igIndex CFD Account but I have not used it for probably 8 years) and the way they work is that when you go to Trade them, the Pricing for the CFD is exactly the same as in the underlying Market. For instance, if I wanted to buy Vodafone VOD on a CFD, the Price in the Market for Normal Shares might now be 212p to Buy VOD and 211p to Sell VOD (please note, these are just rounded up simple examples to aid understanding - in reality the Spread on VOD is probably much tighter), and the Price for VOD to Buy and Sell via a CFD would be the same - 212p/211p.

But CFDs work very much like ‘Daily Funded Bets’ (DFBs) in the Spreadbet world - although there is a Commission Charge, like the Dealing Fee when you buy Normal Shares. So let’s say you wanted to buy a CFD worth £5000 of VOD (this is the Exposure you would have as Normal Shares), in this case your Buy/Sell Spread would be the same as Normal Shares (212p/211p) but because it is a Leveraged Trade, you might only put down £500 and the remaining £4500 of the Trade is financed by you paying a Daily Interest Charge which is deducted out of the Cash in your CFD Account every night. You would also get hit the Commission Charge which might be £10 like most Share Dealing tends to be (I can’t remember if you have to pay Stamp Duty - I have a hunch that you don’t - but for what we are discussing here it is immaterial anyway).

Therefore in effect with a CFD you are buying a Parcel of Shares at the same Price as Normal Shares in the underlying Market but you are taking advantage of Leverage (‘Margin Trading’ is another phrase for it) which is a much more Efficient use of Capital, and you are paying a Daily Financing Charge (like with DFBs this tends to be LIBOR plus 2% or something) for the Money you are borrowing to make the Trade.

I hadn’t intended writing this next bit but I think it makes sense just to help Readers understand what the point of CFDs is. In the example we cited above, let’s imagine VOD rises up to 255p and you managed to Sell it at this Price. If you held £5000 of Normal Shares then you would have made 20% (yes, I rigged the figures to keep it simple !!!) which is a £1000 Return on your £5000 Invested.

If we did the same Example as a CFD, you would have made £1000 Return on your £5000 Exposure just like with the Normal Shares but remember you only had to stump up £500 so your actual Return is £1000 on £500 which is a 200% Return !! Of course in reality you would take a hit on the Financing Charges but if you managed to get the Gains in a few Weeks, then it wouldn’t be much of a hit. But the point is simple - CFDs are a way of using Leverage to spice up your Returns.

How DFBs differ from CFDs
Right, let’s get back to the main flow - as I mentioned earlier, CFDs work very similarly to DFBs in the Spreadbet world - and in recent Years I have been using DFBs for all my Spreadbet Trades pretty much. However, it has struck me that there is a big difference - and that is in the Buy/Sell Spread.

In the VOD example we had above, with the Normal Shares the Buy/Sell Spread was 212p/211p and this was the same for the CFD Trade. However, for a DFB Spreadbet Trade, the Buy/Sell Spread might be 213p/210p. You could argue that on the DFB there is no Commission Charge unlike on the CFD but my suspicion is that the Spread more than makes up for this and the Spreadbet Provider is making a good turn here !!

It is my contention that these Wide Spreads on the DFBs are munching away part of my Returns…….and because the Commission Charge on a CFD is fixed, the bigger your Position the more efficient using a CFD is (just like with Normal Shares in fact) - but with the way the Spreads are working on a DFB, the bigger a Position the more Cost in actual Pounds it is costing my Account.

Monthly Rolling Spreadbets
There might be a solution to this - or at least a way of reducing the eroding effects of the Spreads on DFBs. Whenever I go to Open a new Long Spreadbet Position on a Stock, I am given 4 Choices of Trade I can do. The first one is the DFB and then there is a ‘3 Month Spreadbet’, a ‘6 Month Spreadbet’ and a ‘9 Month Spreadbet’.

As I discussed above, with the DFBs they work very much the same as a CFDs (one of the reasons I like them is that the Price quoted is the closest to the Underlying Market so it sort of mentally makes more sense) with a Daily Financing Charge, but with the Monthly Spreadbets there is no Daily Financing Charge and the Financing is already built into the Buy/Sell Spread - but I think it works out Cheaper.

As an example, for the VOD Trade we discussed earlier, the Buy/Sell Prices might be as follows (please note, these are just made up numbers for simplicity and to aid understanding):

• Normal Shares - 212p/211p
• CFDs - 212p/211p
• DFBs - 213p/210p
• 3 Month Spreadbet - 214p/209p
• 6 Month Spreadbet - 215p/208p
• 9 Month Spreadbet - 216p/207p

Remember the Monthly Spreadbets include the Financing Charge for the Period in their Spread - with the DFB you pay a slightly narrower Spread but you also pay a Financing Charge every Day on top !!

This Bullet Point list also should illustrate what I meant by DFBs being “closest to the Underlying Market” - as you can see as you go down the List the Price gets more and more detached from the ‘Reality’ of the true Underlying Market Price.

So the upshot of this is that I think I might be better off using the Monthly Spreadbets and not the DFBs - however, I have not really figured out whether or not to use the 3 month or 6 Month or 9 Month ones - I guess there is no point doing a 9 month one if you only hold the Position for 4 Months because you will be paying Financing for 5 Months which you don’t hold the Position for. On that basis, I think I will try the 3 Month Bets first off and I will use the ‘Rollover’ Setting that you can globally put on the Spreadbet Account with igIndex to make sure they Rollover to the next 3 Month Contract once they expire. In theory I think this could work but I need to try it out.

However, the sad reality is that this will be a very slow change - I will open New Positions using the 3 Month Contract but I think it is probably best to keep my existing DFB Positions open - if I close them and then re-open as 3 Month Contracts it will incur a lot of cost I think.

Another partial fix
There is something else I could do to reduce this problem but it will only work up to a point. The main reason that I switched from using CFDs to using DFBs was because Spreadbets have a huge advantage in the way they are taxed - despite them actually being really similar to CFDs. As it happens, I had used CFDs for several years and really liked them but then igIndex invented DFBs as a new type of Spreadbet and because of the Tax advantages I switched to using the DFBs and didn’t really think too hard about the much wider Spreads.

DFBs like all Spreadbets are totally Tax Free - this is just such a superb thing and is a big help for Returns. The problem with CFDs is that they attract both Capital Gains Tax (CGT) and normal Income Tax for the Dividends (ah, I forgot about that - with DFBs there is a ‘Dividend Adjustment’ where your Account gets credited with the Divvy on the Ex-Div Day but I think on the Monthly Spreadbets the Dividend is actually allowed for in the Spread already) - so I would only be able to use CFDs up to a point and then I would breach my Tax Limits. At the moment the CGT Limit would be about £11,300 for me and the Income Tax Limit is £11,000 I think - so there is scope to do something here but it would be a bit ’messy’ and obviously I would need to keep a close eye on things to make sure I don’t breach the Tax Limits and have to pay Tax or muck about with Tax Forms and suchlike (at the moment nearly all my Funds are sheltered in ISAs or are used for Spreadbets etc.)

Due to the messiness I am less inclined to go down this route - for now I think I will move to the 3 Month Spreadbet Contracts and see how that goes. I could start doing CFDs again in the Future if I am prepared to manage the Administration side of things carefully - it would probably mean me buying a Normal Shares Position in a Stock, then a Monthly Spreadbet Position and then a CFD Position - this illustrates what I mean about things getting a bit ‘messy’…….

Phew, that was a tough one to write. I bashed it out in about 1 hour 30 minutes but bejesus my Brain hurts now !!

Cheers, WD.