Liquidity & Implementation: A cost comparison: futures versus ETFs
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In this article, we use a cost comparison framework to contrast index futures (CME Group’s E-mini S&P 500 index futures) and three popular US-listed exchange-traded funds (ETFs) tracking the same index – SPY, VOO and IVV.
COST ESTIMATES AND ASSUMPTIONS
The implementation costs for ETFs are relatively simple. ETFs incur trading costs (commissions and price impact costs), holding costs (management fees) and possibly also financing costs (eg, for the deployment of leverage or for short positions).
The implementation costs for futures are only slightly different. In the analysis set out below, we assume a hypothetical institutional investment of $100m.
Transaction costs are expenses incurred in the opening and closing of trades and apply regardless of the investment time horizon.
Commission: commissions are charged by the broker for trade execution. This analysis assumes execution and clearing costs of 0.21bps for E-mini S&P 500 futures and 1.25bps for each ETF.1
Market impact: this measures the adverse price movement caused by executing the order and is dependent on trade size. Given that an order of $100m represents less than 0.04% of the average daily notional value traded in E-mini S&P 500 (ES) futures ($220bn) and 0.45% of the average daily notional value in SPDR S&P 500 ETF (SPY) ($22bn), this analysis assumes a market impact of 1bp for ES futures, 2bps for SPY and 2.5bps for both iShares S&P 500 index (IVV) and Vanguard 500 index fund (VOO).
Holding costs are expenses that accrue over time. Most grow linearly with time (eg, ETF management fees), although there are also some periodic ones (eg, execution fees on quarterly futures rolls). We make the following assumptions.
ETFs: for fully funded investors, the full notional value is deployed. The management fee charged by the fund is 9.5bps per annum for SPY, 4bps for IVV, and 4bps for VOO.2 ETF holders receive dividends.3
Futures: initial margin is required to secure the position. 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 this analysis, we use an implied financing cost of 3-month USD Libor (3mL) plus 16bps.
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. The starting point for each graph in figure 1 represents the round-trip execution costs: 2.10bps for E-mini S&P 500 futures (ES), 6.50bps for SPY, 7.50bps for IVV, and 7.50bps for VOO.
When futures are trading rich, they are the most cost-efficient vehicle for the first three months. After that the ETF 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.
The futures implied financing cost can vary over time and in the scenario where it is valued at a discount to Libor, futures would be the most cost-effective alternative, regardless of holding period.
Scenario 2: international investor
Foreign investors in the US equity markets are subject to a dividend withholding tax at a rate of 30% if those dividends are paid by a US corporation. This tax is also effective in US-listed ETFs paying fund distributions (distribution of dividends received on the equities held by replicating the index), and it takes place quarterly.
For this analysis, the historical 12-month dividend yield of the S&P 500 is assumed to be 2.14%. Dividend withholding taxes therefore add 64.2bps each year to the holding costs for international ETF investors.
Futures, by comparison, do not pay dividends; however, the market price reflects a full dividend-yield basis. As there is no cash distribution, there is no withholding tax increasing the holding costs.4
Figure 2 describes the costs incurred over a period of 12 months. The quarterly steps on the ETF line represent the dividend withholding tax. By the end of the period, the cost difference is 48.13bps.5 In this scenario futures are the more cost-effective vehicle, regardless of the time horizon.
Investors are reminded that the analysis rests on a number of assumptions and should compute the cost for their own specific situation. A useful tool for the transaction cost analysis can be found on the CME website.
1 Transaction cost estimates are based on the average execution fees among institutional clients (based on a survey conducted by CME in December 2018). For details, see Futures are Still on a Roll with the Buyside, Aite Group, March 2019.
2 Source: Bloomberg
3 Dividend withholding tax may apply for non- US investors
4 IRS rule 871m does not apply to E-mini S&P 500 futures and the futures are therefore withholding tax-exempt.
5 Some international investors may be eligible for reduced withholding rates. For a UK investor, whose withholding tax rate is 15% under a double tax treaty with the US, the cost difference would be 16bps.