Futures contracts have traditionally been the go-to vehicle for cash equitization.
Recently, however, we are seeing an increasing adoption of index-based exchange-traded funds in their place. The global ETF industry grew to more than $3.17 trillion in assets under management as of June 30. At the same time, the increasing size and trading volume of ETFs have boosted their liquidity and market depth and lowered transaction costs, like the bid–ask spread.
The main drivers of this evolution include the need for increased certainty of transaction costs as the cost of investing in futures has become more volatile and less certain at the time of roll, when traders carry over an expiring contract to a later month — potentially driving up trading costs relative to historical norms.
Shifting supply and demand forces in the marketplace, changes in the financial regulatory environment and shifting supply are pushing up futures costs. Since 2012, the pricing of the roll of e-mini S&P 500 futures has become more volatile and is often a rich trade relative to fair value. According to a 2016 report by CME Group, the recent richness is attributable in part to changing supply and demand dynamics, specifically natural sellers and liquidity providers on the supply side of the market. Because of steadily rising markets in recent years, investors have reduced their short exposure, which boosted demand on liquidity providers on the short side, including financial institutions. This higher demand increased the implied financing of futures.
On the regulatory front, the Dodd–Frank Wall Street Reform and Consumer Protection Act, Basel III and other reforms put in place after the financial crisis have shored up the industry and sought to address systemic risks, but they have also created consequences for investors. The new regulatory landscape has made holding and rolling futures contracts more expensive as a result of a higher cost of capital for financial institutions.
This confluence of factors has led institutional investors to explore ETFs as an alternative to futures, particularly in highly liquid asset classes. In addition, ETFs can be used to access efficient, low-cost and liquid exposure to a broad range of asset classes — many of which do not have liquid futures options.
When it comes to the S&P 500 index, ETFs can be a great option for fully funded, unleveraged positions. The ETF tracking the S&P 500 index is the most traded, listed equity security in the world, with average daily volumes of more than $25.6 billion and bid–ask spreads of a penny. Depending on prevailing market conditions, owning an ETF can be less expensive than e-mini S&P 500 futures contracts for even a single day or week. The cost advantage of the ETF only grows along with the holding period as additional rolls are taken into consideration, and that helps explain the attractiveness of highly liquid ETFs for institutional investors. Both futures and ETF holding costs include tracking error, bid–ask spreads and trading commissions when buying and selling. Once an ETF is purchased, the only holding cost is the fund’s expense ratio, as that does not need to be rolled.
Of course, the ETFs-versus-futures evaluation depends on the investor, position size, holding period — more future rolls often equate to higher costs — and other factors such as whether the long position is fully funded.
Tim Coyne, based in New York, is head of institutional sales and global capital markets for SPDR ETFs, and Rob Trumbull, based in Boston, is head of asset owner ETF sales, both at State Street Global Advisors.
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