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Ten years into the current bull market, the US stock market has been inching up with little volatility for an extended period. Meanwhile, the investment management industry has also seen a relentless drive to wring out costs. A good grasp of implementation cost of using different vehicles for the same strategy matters. Here, a cost comparison framework will be described for contrasting index futures and comparable exchange-traded funds (ETFs). CME Group’s E-mini S&P 500 index futures (ES) is compared with the top three US-listed ETFs of the same underlying index. The same framework can be applied to other indices as well.
Cost estimates and assumptions
Implementation cost estimates for using ETFs are relatively simple. There are trading costs associated with acquiring and disposing of the positions (commissions and price impact costs), holding cost (management fee), as well as other financing related cost applicable to some situation, for example, deployment of leverage or short positions.
Implementation cost for deploying futures is only slightly different. They also include the trading costs (commissions and price impacts), holding cost (associated with financing a position), as well as other financing costs.
For the purposes of this article, the conclusions are derived for a hypothetical investment of $25m (€21.4m).
Transaction costs are expenses incurred in the opening and closing trades.
• Commission: Commissions are charged by the broker for trade execution, which varies. This analysis assumes execution costs of $3.54 per contract (0.35bps) for E-mini S&P 500 futures and $0.08 per share (4.1bps) for each ETF.1
l Market impact: It measures the adverse price movement caused by the act of executing the order. Market impact is dependent on trade size. Given that an order of $25m represents less than 0.01% of average daily notional value traded in the ES future ($230bn) and 0.08% of average daily notional value in SPDR S&P 500 ETF (SPY – $32.2bn), it is reasonable to assume minimal market impact beyond the cost of crossing the bid-ask spread. This analysis, therefore, estimates one tick increment for ES (1.25 bps) and SPY (2.0bps), and four ticks for iShares S&P 500 Index (IVV – 2.5bps) and Vanguard 500 Index Fund (VOO– 2.5bps).
Holding costs are expenses that accrue over time. Most grow linearly with time (for example, ETF management fees) although there are some periodic ones (eg, execution fees on quarterly futures rolls). The following assumptions are made.
• ETFs: For fully funded investors, the full notional value is deployed. Management fee charged by the fund: 9.5 bps per annum for SPY, 4bps for IVV, and 4bps for VOO. Holders receive dividends.2
• Futures: Initial margin is required to secure the position. Investors can pledge securities, money market funds (or cash) to meet the requirement and receive income from the collateral during the holding period.
Unlike ETFs, futures do not carry management fees. But an implied financing cost is embedded in the price. This financing cost is the difference between the financing rate priced into the futures, and the income received from the collateral. This financing spread varies over time but is locked in place at the time of initiating or rolling the position.
For a long investor who has access to collaterals generating income at Libor rate, the futures implied financing less Libor would be the financing cost of the position.
For this analysis, the futures trading at three-month USD Libor (3mL) +20bps is used when futures are rich and 3mL –5.7bps is used when futures are cheap.
In each case, the total cost is computed for a holding period of 12 months. All scenarios assume the same transaction costs and market impact at both trade initiation and exit.
Scenario 1: Fully-funded long investor
For a fully-funded investor, the total cost is the sum of transaction costs plus the pro-rated annual holding costs. Each analysis starts at the round-trip execution costs: 2.10bps for ES, 6.50bps for SPY, 7.50bps for IVV and 7.50bps for VOO. as time passes, the annual holding costs will gradually accrue, with small jumps in the costs of futures due to the quarterly roll costs.
When futures are trading rich (3mL +20bps), ES is most cost efficient up until the fourth month. At the breakeven point (approximately 91 trading days), the ETFs becomes the cheaper alternative as the implied richness of futures becomes greater than the drag on performance generated by the management fee of the ETF.
When futures implied financing is valued at a discount to Libor (3mL –5.7bps), the negative financing spread provides long investor a distinct advantage. Futures can be the most cost-effective alternative in to perpetuity.
Scenario 2: Leveraged investor
Futures are inherently friendly to deploying leverage. As of this writing, initial margin requirement for E-mini S&P 500 futures is only approximately 4.01%. A leverage ratio over 20 is possible.
For ETF users, leverage could be limited by applicable strictures such as the Regulation T of the Federal Reserves. Under Reg T, a maximum of 2x leverage is feasible. As such, comparison is limited to the 2x ratio. The calculation in scenario 1 is redone with the following adjustment to account for the use of 2x leverage.
For futures position holders, the income generated by the collateral is reduced in half to account for the fact that only half the notional investment value is “funded”.
For ETFs, explicit interest cost is added to the holding cost calculation. Margin loan rate varies widely. It is, however, likely to be linked to short-term interest rate benchmarks. In this calculation, however, a very low margin loan rate of 1.80% p.a. is assumed.
Figure 1 shows that as a function of leverage, the total cost associated with futures will never exceed that of the ETFs, making futures more economically attractive for the leveraged investor even if the implied financing is rich.
1 Transaction cost estimates are based on the average execution fees among the largest retail brokers.
2 Dividend withholding tax may apply for non-US investors.
Richard Co is executive director and Tom Rafferty is manager in the equity products division at CME Group
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Implementation: A cost comparison of futures and ETFs