The Big Picture: A Cost Comparison of Futures and ETFs

Second Edition

1  FEBRUARY 2016  |  © CME GROUP

EXECUTIVE SUMMARY

• Thisreportcomparestheall-incostofreplicatingtheS&P500totalreturnviaequityindexfutures

andexchange-tradedfunds(ETFs)acrossavarietyofusecasesandtimehorizons.

• ThespecificproductsusedintheanalysisaretheCMEE-miniS&P500futureandthethree

U.S.listedS&P500ETFs:theSPDRSPY,iSharesIVVandVanguardVOO.

• Theanalysisbeginswithadetailedlookatthecomponentsoftotalcostandtheassumptions

thatunderliethecalculations,whichincludesobservationsaboutrecentchangesintheimplied

financingratesoffuturesandthedriversofthesemoves.

• Thetotalcostofindexreplicationacrossarangeoftimehorizonsiscalculatedforfourcommon

investmentscenarios:afully-fundedlongposition,aleveragedlong,ashortpositionanda

non-U.S.investor.

• ThechoicebetweenfuturesandETFsisnotaneither-ordecision.E-miniS&P500futuresare

showntobemorecost-effectivethanS&P500ETFsforleveraged,shortandnon-U.S.investors

acrossalltimehorizons.

• Forfully-fundedinvestors,theoptimalchoiceisafunctionoffuturesimpliedfinancingand

investmenttimehorizon.Whentherollcostoffuturesissub-Libor,investorsareunequivocally

betterservedbyfutures,andiftherollcostisatapremiumtoLibor,themostcostefficient

alternativecouldbeeitherafutureoranETF.

Scenario

Cheapest Option

Roll is Cheap (Below 3-month USD Libor)

Roll is Rich (Above 3-month USD Libor)

Fully-Funded Futures Depends on holding period and degree of richness

Leveraged(2x,8x) Futures Futures

ShortSeller Futures Futures

International Futures Futures

Scenario: Fully-Funded, Roll Cost at a Premium to 3-month USD-Libor

Spread to 3-month USD-Libor

E-mini S&P 500 futures are more cost effective than ETFs for all investors when the Roll Cost trades at, or below, the following holding periods:

30 Days 60 Days 90 Days 180 Days 1 Year 2 Year 4 Year

+51bps +30bps +20bps +11bps +6.3bps +4.0bps +2.9bps

2  FEBRUARY 2016  |  © CME GROUP

INTRODUCTION

This report compares the all-in cost of replicating the S&P

500 total return1 via equity index futures and ETFs.

Given the diversity of clients and potential uses for both

ETFs and futures, there is no “one-size-fits-all” answer to

the question of which is more cost-efficient. The optimal

choice depends on the details of both the client and the

specific trade.

The approach is, therefore, to consider four common

investment scenarios – a fully-funded long position, a

leveraged long, a short position and a non U.S. investor –

and compare the costs of index replication with futures

and ETFs in each. While these scenarios do not represent

all possible applications for either product, they cover

the majority of use cases, and analysis of the scenarios

provides insights into factors that investors should

consider when making their implementation decisions.

This analysis compares the CME E-mini S&P 500 future

(ticker: ES) with the three US-listed S&P 500 ETFs: SPDR

S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV) and

Vanguard S&P 500 ETF (VOO).

COST ESTIMATES AND ASSUMPTIONS

The goal of this report is to quantify the cost of replicating

the total return of the S&P 500 index over a given period of

time using equity index futures and ETFs. The framework

for analysis will be that of a mid-sized institutional investor

executing through a broker intermediary (i.e. not direct market

access, or DMA) for a hypothetical order of $100 million.

The total cost of index replication is divided into two

components: transaction costs and holding costs.

Transaction Costs

Transaction costs are expenses incurred in the opening and

closing of the position. These apply equally to all trades,

regardless of the time horizon.

Commission: The first component of transaction cost is the

commission, or fee, charged by the broker for the execution.

These charges are negotiated between parties and vary

from client to client. This analysis assumes execution costs

of $2.50 per contract (0.25bps) for E-mini futures and 2.5

cents per share (1.25bps) for ETFs.2

Market Impact: The second component of transaction

costs is market impact, which measures the adverse price

movement caused by the act of executing the order.

Market impact can be very difficult to quantify. In the

simplest case – an unlimited market order sent directly to

the exchange – the impact can be accurately defined as the

difference between the market price immediately prior to

the order being submitted and the final execution price of

the trade. However, as the execution methodology becomes

more sophisticated and extends over a longer period of

time (e.g. a working order participating at 25 percent of

the volume, or an over-the-day VWAP target) it becomes

increasingly difficult to separate the impact that was caused

by the trade from market movements unrelated to the trade.

The analysis in this report requires an estimate of the

expected market impact from a hypothetical execution, rather

than the actual impact of any specific trade. This anticipated

impact is therefore a statistically-based estimate and may be

very different from that of any particular execution.

In deriving this estimate for the anticipated market impact,

it is important to factor in the transfer of liquidity that

occurs between different products tracking the S&P 500.

1 Price return plus dividends.

2 These rates are indicative of typical “middle-of-the-range” pricing for institutional clients. While commissions and fees are a focus for short-term traders, in the context of the longer-term analysis here, they make only a very small contribution to the total cost.

3  FEBRUARY 2016  |  © CME GROUP

When facilitating investor orders in any one of the products

under consideration, liquidity providers will hedge with the

least expensive alternative between futures, ETFs and the

replicating stock portfolio. This creates a “pool” of S&P 500

liquidity in which each product benefits from the liquidity

of the others, which in turn greatly increases the liquidity of

all products.

Based on broker estimates and CME Group’s own analysis,

the market impact of the hypothetical $100 million order is

estimated to be 1.25bps for E-mini futures, 2.0bps for the

SPY ETF, and 2.5bps for both IVV and VOO.

Table 1: Liquidity Comparison

Product AuM / OI ($Bn) ADV ($Mn)

ES 285.0 173,102

SPY 172.9 25,311

IVV 66.1 909

VOO 40.2 382

Fullyear2015ADV.AuM/OIasof1February,2016.Source:CMEGroupandBloomberg.

As a “sanity check” on these values, it is observed that

$100 million represents 0.06% of the average daily notional

value traded in the ES future of approximately $173 billion

(2015 average). As such, a 1.25bps impact estimate –

equivalent to one tick increment – appears reasonable.

Given that the liquidity of the ES future is nearly 7x that

of the SPY and more than 130x that of the IVV and VOO

combined, the impact estimates for these products initially

appear quite low. However, if one factors in the liquidity

pool effect in the S&P 500 and the frictional costs of

converting between the various products, the incremental

cost of 0.75bps for SPY and 1.25bps for IVV and VOO –

corresponding to approximately 1.5cps and 2.5cps,

respectively – appear reasonable.

Holding Costs

Holdingcostsareexpensesthataccrueoverthetimethe

positionisheld.Thesegenerallygrowlinearlywithtime

(e.g.ETFmanagementfees,whichaccruedaily)although

therearesome,whicharediscretebutrecurring(e.g.

executionfeesonquarterlyfuturesrolls).

ThesourcesofholdingcostsforETFsandfuturesare

different,owingtotheverydifferentstructuresofthe

twoproducts.

ETFs: TheholdingcostofanETFisthemanagementfee

chargedbythefundfortheserviceofreplicatingtheindex

return(generallythroughthepurchaseandmaintenance

oftheunderlyingstockportfolio).Themanagementfee

forthethreeETFsinouranalysisrangesbetween5.0and

9.45bpsperannum.

Asecondpotentialsourceofholdingcostistrackingerror

betweenthefund’sreturnsandthoseoftheindex(other

thanthoseduetotheapplicationofthemanagementfee).

Thisriskwillbeignoredintheanalysisthatfollows,asit

hasneverbeenanissuewiththeETFsunderconsideration

andassuch,thereisverylimitedbasisforestimatingthe

magnitudeorimpactofpotentialdeviations.

Futures:Futurescontractsarederivativesandprovide

leverage.UnlikeanETF,wherethefullnotionalamount

ispaidbythebuyertothesellerattradeinitiation,with

futurescontracts,nomoneychangeshandsbetweenthe

parties.Rather,bothbuyerandsellerdepositmarginof

approximately5.2percent3ofthenotionalofthetrade

withtheclearinghousetoguaranteetheirobligations

underthecontract.

3 At time of writing the margin requirement on E-mini S&P futures is $4,700 on a contract notional of roughly $91,300. Margin amounts are subject to change.

4  FEBRUARY 2016  |  © CME GROUP

AscomparedwiththeETFmanagementfee,buyersof

futurescontractsareimplicitlypayingthesellersnotonly

toreplicatetheindexreturns,butalsotodosowiththeir

ownmoney.Asaresult,thepriceofafuturescontract

containsacomponentthatrepresentstheinterest

chargesonthese“borrowed”funds4.

Giventhetradingpriceofthefutures,onecaninfertherate

thatthemarketisimplicitlychargingonthese“borrowed”

funds.Whilethisfundingcostisimpliedinallfutures

transactions,itismostreadilyinferredfromtradinginthe

futuresrollandfrequentlyreferredtoasthe“rollcost.”

Comparingthisimpliedinterestratewiththecorresponding

USD-Liborrateoverthesameperiod,onecancalculatethe

spreadtoLiboranddeterminewhetherthefutureisrolling

“rich”(impliedfundingaboveLibor,positivespread)or

“cheap”(impliedfinancingbelowLibor,negativespread).

Forafully-fundedinvestor(i.e.onethathascashequal

tothefullnotionalvalueoftheposition),therichnessor

cheapnessoftherollisnotmerelya“theoretical”costbut

theactualholdingcostforindexreplicationviafutures.The

investorrealizesthiscostbybuyingthefuturescontracts

andholdinghisunusedcashinaninterest-bearingdeposit.

Throughthefuturescontracts,hepaystheimplied

financingrateonthefullnotionalofthetrade,whileonthe

unusedcashondeposithereceivesarateofinterest,which

isassumedtobeequalto3-monthUSD-Libor(3mL)5.The

differencebetweentheinterestpaidandinterestearnedis

theholdingcostofthepositionandisequaltotherichness

orcheapnessoftheroll.

Observations on the Futures Roll

Unlikeamanagementfee,theimpliedfinancingcostof

thequarterlyfuturesrollisnotconstantbutdetermined

bytheforcesofsupplyanddemandandarbitrage

opportunitiesinthemarket.

Historically,theimpliedspreadtoLiborofESfutureswas

belowthelowestmanagementfeesonanyETF.Overthe

ten-yearperiodbetween2002and2012,theESfuturesroll

averaged2bpsbelowfairvalue6.

Since2012,thepricingoftherollhasbecomemorevolatile

andtradedatvariedlevelsasshowninFigure1,withthe

richnessaveraging35bpsin2013,26bpsin2014and8bps

in2015.

Thisrecentrichnessisattributabletotwomainfactors:

changesinthemixbetweennaturalsellersandliquidity

providersonthesupply-sideofthemarket,andchanges

tothecostsincurredbyliquidityproviders(particularly

banks)infacilitatingthisservice.

Inabalancedmarket,naturalbuyersandsellerstradeata

priceclosetofairvalue–neitherpartybeinginaposition

toextractapremiumfromtheother.Whennonatural

sellerisavailable,aliquidityproviderstepsintoprovide

supply(i.e.sellfutures)ataprice.Thegreaterthedemand

onliquidityproviders,thehigher(andmorevariable)

theimpliedfundingcostswillbe.Conversely,ifmarket

conditionsattractmorenaturalsellers,thisdemandon

liquidityproviderscanbediminishedviatheredistribution

amongstmarketparticipants,whichwillbothstabilizeand

lowertheimpliedfundingcosts.

4 The argument is symmetric for the seller. The short sale of an ETF would generate cash, which would earn a rate of interest. The sale of a futures contract generates no cash, and so the implied interest in the futures price compensates the seller for this.

5 As with other assumptions in the analysis, this value represents a “middle-of-the-range” yield on uninvested cash.

6 Goldman Sachs, “Futures-Plus”, 22 January, 2015.

5  FEBRUARY 2016  |  © CME GROUP

Figure 1: S&P 500 Futures Roll Richness with High/Low Range7

Mar

-11

Jun-

11

Sep-

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Dec

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Mar

-12

Jun-

12

Sep-

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Dec

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Mar

-13

Jun-

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Sep-

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Dec

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Mar

-14

Jun-

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Sep-

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Mar

-15

Jun-

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Sep-

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Fina

ncin

g Sp

read

vs.

3m

L

(40)

(20)

0

20

40

60

80

Average Weighted Roll (3 Weeks Prior to Expiration)

High Low Average Daily Roll Rate Range

ThepersistentlystrongS&P500returnsfrom2012to

2014(averageannualgrowthof20.2percent)causeda

decreaseinthesizeofthenaturalshortbase,as

institutionalinvestorsreducedshortsandbiasedtheir

positionstowardlongexposure.Thisincreaseddemandon

theremainingshort-sideliquidityproviders–e.g.

leveragedshorts,hedgefundsandU.S.banks–occurred

atatimewhenaccesstobalancesheetandfundingwere

increasing,allofwhichplacedupwardpressureonthe

impliedfinancingoffutures,asdisplayedinFigure1.

The-0.73percentstagnantreturnoftheS&P500

in2015coupledwiththeresurgenceofvolatilityin

equitymarketsinthelatterpartof2015andearly2016

increasedthenaturalshortbaseinthemarketand

exerteddownwardpressureonfutures’impliedfinancing

levels.Thissequenceofeventsandcheapeningoftheroll

demonstratethattherollmarketiscontrolledbyseveral

complexfactorsandthattheaforementionedfactors

thatappliedupwardpressureonimpliedfinancing

costsdidnotrepresentpermanentshiftsinthemarket,

norwasonefactordominantindrivingtheembedded

richness.Meaning,iftheprimarydriveroftheroll

richeningwasbelievedtobetheregulatoryandcapital

pressuresononesegmentofliquidityproviders–U.S.

banks,forexample–therollrichnesswouldnothave

abatedby50bpsfromDecember2014toDecember2015

whiletherewasnoconcurrentshiftin,orrelaxationof,

theregulatoryorcapitalregimeintheU.S.

In2014,therollmarketbegantorenormalizewiththe

March,JuneandSeptemberrollsaveragingjust17bps

(lessthanhalftheDecember2012toDecember2013

level)andtradingaslowas7bpsinSeptember8.The

subsequentrichnessoftheDecember2014rollindicates

thatsomeyear-endeffectsremained.Throughout2015,

asaresultofmarketconditions,arebalancingofmarket

long-shortbiasandnewparticipantsextractingpremium

viatheabove-marketfinancingrates,therollmarket

cheapenedto2012levels,withboththeSeptemberand

December2015rollperiodstradingatsub-Liborlevels.

Intheanalysisthatfollows,E-miniS&P500futuresare

evaluatedagainstthecorrespondingETFsintwoscenarios

wherethefuturesareassumedtorollatthe2014-2015

two-yearaverageof20bpsabove3mL,andattheH2-2015

sub-Liboraverageof5.7bpsbelow3-monthUSD-Libor.

Table2summarizesthecostestimatesusedinthe

analysis.Theexecutionfeesofthequarterlyfuturesroll

areassumedtobethesameasinthetransactioncost,

appliedtwiceateachroll.

Table 2: Summary of Assumptions (in bps)

Product Execution Fees

Market Impact

Holding Cost (per annum)

ES 0.25 1.25 20.0/-5.7

SPY 1.25 2.00 9.45

IVV 1.25 2.50 7.0

VOO 1.25 2.50 5.0

7 The blue line shows the weighted average richness of the roll over the three weeks leading up to expiry, and the grey bars indicate the highest and lowest average daily rate over the period.

8 Source: CME Group Equity Quarterly Roll Analyzer tool

6  FEBRUARY 2016  |  © CME GROUP

SCENARIO ANALYSIS

Havingestablishedbaselinetransactionandholdingcost

estimates,itisnowpossibletocomputethetotalcost

ofindexreplicationviafuturesandETFsforvarioususe

cases.Thisreportwillconsiderfourscenarios:afully-

fundedinvestor,aleveragedinvestor,ashortsellerandan

internationalinvestor(i.e.non-U.S.domicile).Ineachcase,

totalcostiscomputedforallholdingperiodsupto

12months.

Allscenariosassumethesametransactioncostsand

recognizetheround-tripfeesandmarketimpactat

tradeinitiation.Futuresrollcostsareassessedonthe

Wednesdaybeforeeachquarterlyexpiry.

Whileitisnotspecificallymentionedintheexplanations

ofeachscenario,allfuturescarrycalculationshavebeen

adjustedforthemargindepositedwiththeCMEclearing

house,anditisassumedtonotearninterest.Atcurrent

interestratestheimpactisapproximately1.3bpsperannum.

Scenario 1: Fully-funded Investor

Forthefully-fundedinvestor,thetotalcostofindex

replicationoveragivenperiodisthesumofthetransaction

costsplusthepro-rataportionoftheannualholdingcosts.

Figure2showsthecostofindexreplicationviaindex

futuresandETFsfortimehorizonsouttosixmonths,

assumingaJanuarythroughJuneholdingperiodandthe

transactionandholdingcostestimatesinTable2.

Figure 2: Fully-funded Investor, 6 months

-

Tota

l Cos

t (bp

s)

Holding Period

2

4

6

8

10

12

14

16

VOOIVVSPYES Futures (-0.06%)ES Futures (+0.20%)

Thestartingpointforeachgraph(theintersectionwiththe

verticalaxis)representstheround-tripexecutioncost,

rangingfrom2.9bpsforfuturestobetween6.5and7.5bps

forETFs.Mostofthelinesslopeupwardastimepasses,

reflectingthegradualaccrualoftheannualholdingcosts,

withsmalljumpsinthefutureslineduetothecostof

quarterlyfuturesrolls.Becausetheannualmanagement

feesontheETFsarebelowanimpliedrichnessof+20bps

onfutures,thegraphsoftheETFsslopeupwardmore

slowlythanthatofthefutures.Theoppositeholdstrue

whenfuturescarryanimpliedcheapnessandthe

downwardslopeofthelinerepresentsthepremiumthat

canbeextractedviarollingfuturescheaptoLibor.Atan

impliedcheapnessof-5.7bps,theETFmanagementfees

areabovetheholdingcostofthefuture,andthisdivergent

relationshipexistsfortheentireperiod.

7  FEBRUARY 2016  |  © CME GROUP

Forshortholdingperiods,thehighertransactioncostsof

theETFsmakethefuturesmoreeconomicallyattractive

regardlessoftherollrichnessorcheapness(futuresline

belowallthreeETFlines).Thismakesfuturesaparticularly

attractivetoolformoreactive,tacticalandshort-term

traders.Forlonger-termholders,thecumulativeeffectsof

impliedfinancingmaketheETFamoreefficientalternative

whenfuturesarerollingrich,andlessefficientwhenfutures

arerollingcheap.

At3mL+20bps,thebreakevenpointatwhichETFsbecome

amoreeconomicallyefficientalternativeoccursinthe

fourthmonth.Inthisspecificexample,theVOObreakeven

arrivesfirstonday91,followedbytheSPYonday94and

theIVVonday104.However,at3mL-5.7bps,theETFsnever

reachabreakevenpointandfuturesremainthemorecost-

effectivealternativeinperpetuity.Tobeclear,itisnotjust

theswitchfromrichtocheapthatmakesfuturesmorecost

effective,overtimeitistherelationshipbetweenthefutures

embeddedspreadtoLiborandtheETFmanagementfee.

Infact,iftheimpliedfinancingoftherolltradesrichat,or

lowerthan3mL+2.9bps,futureswillremainbetterthan

theETFoverafour-yearholdingperiod,astheembedded

richnessislessthanthedragonperformancegeneratedby

themanagementfeeassociatedwithholdingtheETFs.

InFigure3,wheretheanalysisisextendedouttoa

12-monthholdingperiod,whenfuturesrollat3mL+20bps,

onecanseethatETFsarecheaperthanfuturesbybetween

10.3and13.7bps,andatthe3mL-5.7bpsrolllevelfutures

arecheaperthantheETFsbybetween12.0and15.5bps.

Figure 3: Fully-funded Investor, 12 months

-

Tota

l Cos

t (bp

s)

Holding Period

2

4

6

8

10

12

14

16

18

20

22

24

26

28

ES Futures (+0.20%) ES Futures (-0.06%) SPY IVV VOO

Scenario 2: Leveraged Investor

Equityindexfuturesareleveragedinstruments.The

investorpostsapproximately5percentmargintothe

exchange,whichresultsinover20xleverageontheir

position.ThethreeETFsinthisanalysisarenotleveraged9

butmaybepurchasedonmarginbyinvestorswhodesire

leverage.

Thedifferenceisthequantityofleveragethatispossible.

UnderFederalReserveBoardRegulationsTandU,there

arelimitsontheamountabrokermaylendtoaninvestor

wishingtopurchasesecuritiesonmargin.

UnderRegT,themaximumamountthatcanbelentis50

percentofthepurchaseprice,resultinginamaximumof

2xleverage.Moresophisticatedinvestorsmaybeeligible

forportfoliomarginingthroughaprimebrokerunder

whichtheycouldpotentiallyachieve6-8xleverageunder

RegU.Greaterthan8xleverageisnotpossible.

ToderiveaholdingcostfortheETFpositionpurchased

withleverage,standardprimebrokerlendingratesforan

institutionalclientof3mL+40bpsareassumed.

9 Leveraged ETFs are excluded from this analysis, as these have path-dependent returns which are very different from standard ETFs or futures.

8  FEBRUARY 2016  |  © CME GROUP

Two-times Leveraged Investor

Thestartingpointfortheanalysisisthe2xleveragedcase.

Thisimpliesthattheinvestorhas$50millionwithwhich

totakeon$100millionofexposure.

TheETFinvestor,whomustpaythefullnotionalamount

ofthetradeatinitiation,borrows$50millionfroma

primebrokertofundthepurchase.Theholdingcostof

theleveragedpositionisthereforethesameasthefully-

fundedposition(Scenario1)plustheinterestcarryonthe

borrowed$50millionat3mL+40bps.

Withfutures,itisnotaquestionofborrowingmoney,as

aninvestorwith$50millionalreadyhasapproximately

10xtherequiredmargindeposit.Rather,itisacaseof

havinglessmoneytodeposittodefraythe3mLbaseline

financingcostembeddedinthefutures.Inthefully-funded

case,itwasassumedthattheinvestor’s$100million

depositearnedinterestat3mL,whichfullyoffsetthe3mL

componentofthefuturesimpliedfinancingrate;leaving

onlythepositive(ornegative)spreadtoLiborasthe

financingcost(orcredit)onholdingtheposition.Inthe2x

leveragedcase,theamountofcashavailabletodepositis

reducedby$50million,andtheinvestor’sdepositcanonly

generateenoughinteresttooffsethalf($50million)ofthe

3mL-basedfinancingonthetotalfuturesnotional($100

million).Asaresult,the2x-leveragedinvestorwillincurthe

embeddedbaseline3mLfinancingcostontheremaining

halfofthefuturesnotional,plustheentireexpenseofthe

positivespread(orlessthecreditofthenegativespread)

to3mLonthefullfuturesnotional($100million),aswas

depictedinthefully-fundedscenario.Viewedthisway,the

holdingcostofthe2xleveragedscenarioforfuturesis

identicaltothefully-fundedscenarioplusthenewinterest

expenseon$50millionat3mL.

Figure 4: Total Cost for 2x and 8x Leverage, 12 months10

-

10

20

30

40

50

60

70

80

90

100

110

Holding Period

Avg. ETFs, 2x Avg. ETFs, 8x ES Futures (+0.20%) 2xES Futures (+0.20%) 8x ES Futures (-0.06%) 2x ES Futures (-0.06%) 8x

Tota

l Cos

t (bp

s)ThedashedlinesinFigure4showthetotalcostofindex

replicationona2xleveredbasisforholdingperiodsupto

12months.

Comparedtothefully-fundedscenarioinFigures2and3,the

totalcosthasincreasedforbothETFandfuturespositions.

However,duetoabove-Liborrateschargedonborrowed

fundsbyaprimebroker,theETFholdingcosthasincreased

by20bpsperannummorethanthefutures(40bpsspread

ononehalfofthetradenotional).Asaresult,futuresarethe

moreeconomicaloptionacrossalltimehorizons.

Eight-times Leveraged Investor

Theanalysisforthe8xleveragedcaseproceedsina

similarfashion.Inthiscase,theinvestorhas$12.5million

ofcashwithwhichtoobtain$100millionofexposure.

TheETFinvestorthereforehasan$87.5millionloanfrom

theprimebroker,whilethefuturesinvestorhasan$87.5

millionreductionintheirdeposit.

10 To simplify the graphical representations, Figures 4-6 show the average of the total costs of the SPY, IVV and VOO. The individual results for each ETF are within ±2bps of the value shown at all time horizons.

9  FEBRUARY 2016  |  © CME GROUP

ThesolidlinesinFigure4showthecostcomparisonfor

the8xleveredcase.Astheamountoffundsborrowed

increases,theincrementalborrowingcostofaprime-

brokerfundedETFpositionincreases,ascomparedwith

theincreasedintrinsiccostofleverageembeddedin

thefutures.Inthe8xleveredcase,the40bpsfunding

differentialon87.5percentofthenotionalofthetrade

resultsina35bpsgreaterincreaseintheholdingcostof

ETFsrelativetofutures.

ThecostadvantageoffuturesoverETFsforaone

yearholdingperiodwhenfuturesaretradingrichat

3mL+20bpsis8.2and23.2bpsforthe2xand8x

leveragedcases,respectively;andatH2-2015levelsof

3mL-5.7bps,thecostadvantageoffuturesimproves

to33.9bpsand48.9bpsforthe2xand8xleveraged

investor,respectively.

Thisanalysishasbeenconductedusingcurrent3mLrates

ofapproximately0.60percent.Asinterestratesrise,the

absolutecostofleveragedexposurewillincreaseforboth

products.However,thedifferencebetweentheholdingcosts

ofETFsandfuturesisnotafunctionoftheabsoluteratebut

ofthespreadbetweencashondepositandborrowedcash

andpersistsacrossdifferentinterestrateregimes.

Scenario 3: Short Investor

Ashortpositionprovidesnegativemarketexposureandis

inherentlyleveraged.

WithETFs,theleveragecomesintheformofaloanof

sharestosellshortbyaprimebroker.Thesaleofthe

borrowedsharesraisescash,whichremainsondeposit

withtheprimebroker.Theshortsellerpaysabpsper

annumfeetothelenderoftheETF,whichisdeducted

fromtheinterestpaidonthecashraisedbythesale.

Atypicalprimebrokerborrowfeeof40bpsperannum

isassumed,resultinginareturnoncashraisedof

3mL–40bps11.

Inadditiontothecashraisedfromtheshortsale,the

investormustpostanadditional50percentofthe

notionalofthetradeincashtothebrokerasmargin12.

Theadditionalfundspostedtotheprimebrokerwillbe

assumedtoearn3mL.

Becausetheyareusingderivatives,theshortseller

offuturesdoesnotneedtoborrowsharesorpaythe

associatedfee.Thesaleofafuturescontractisidentical

tothepurchase,withthesamemarginpostedwiththe

clearinghouse.

Whenanalyzingtheeconomicsofashortposition,itis

importanttorememberthattheholdingcostsforthelong

investorbecomebenefitsfortheshort.ETFmanagement

feescauseasystematicunderperformancerelativetothe

benchmarkwhich,fortheshortinvestor,representsan

excessreturn.Therichnessofthefuturesrollprovidesa

similarbenefitforfuturesinvestors.

11 This rate, combined with the assumption on long funding of 3mL + 40bps, results in an 80 bps “through-the-middle” prime broker bid / offer, which is consistent with market standards.

12 Higher leverage may be eligible under portfolio margining, but we will focus on the 2x levered case.

10  FEBRUARY 2016  |  © CME GROUP

TheholdingcostsforshortpositionsinfuturesandETFs

canbedecomposedasfollows:

Futures:

1) Receivefutures’impliedfundingrateof3mL+20bps

onthe$100million

2) Receive3mLon$50millioncash

ETFs:

1) Receivethemanagementfeeof5-9.45bps

2) Receive3mL-40bpson$100millionraisedfromthe

shortsale

3) Receive3mLonthe$50milliondepositedwiththe

primebroker.

Figure5showsthatinbothcasestheholdingcostsare

negative–overtime,theinvestor’srelativeperformance

versustheshortreturnofthebenchmarkimproves,as

demonstratedbythedownwardslopeoftheline.

However,duetothecombinationofhigherETFtransaction

costsandthefundingspreadschargedbyprimebrokers,

thefuturesprovideamorecost-effectiveimplementation

acrossalltimehorizons,regardlessiffuturesaretrading

richorcheap.Whileitismathematicallyandtheoretically

possiblethatthecheapnessembeddedinthefutures

couldbesonegativetoLiborthatthePrimeBrokerrebate

ratecouldtradelessnegativeandoutpacethefuturein

theshortscenario,thiswouldneverhappeninrealitygiven

theinterrelatednessoftheS&P500products.Asthe

embeddedfinancingcheapened,thePrimeBrokerwould

havetolowertheirspreadtomorenegativelevelstoearn

aprofitoverandtokeeppacewiththetrueassetvalue

rebateoftheS&P500thatisgenerallybetterreflectedin

thefuture.

Thecostadvantageoffuturesatthe3mL+20bps

rollcostoverETFsfora12-monthholdingperiodis

53.8bps,andevenwhenfuturesfinancingistrading

atthesub-Liborlevelof3mL-5.7bps,futuresarestill

morecosteffectiveby28.1bps.

Figure 5: Short Futures vs. ETF, 12 months

(110)

(100)

(90)

(80)

(70)

(60)

(50)

(40)

(30)

(20)

(10)

0

10

20

Tota

l Cos

t (b

ps)

Holding Period

ES Futures (+0.20%) ES Futures (-0.06%) Avg. ETF

Scenario 4: International

CME Group does not provide tax advice. Investors should consult

their own advisors before making any investment decision.

Ingeneral,foreigninvestorsintheU.S.equitymarketare

subjecttoawithholdingtaxondividendpaymentsbyU.S.

corporations.Thebasewithholdingrateis30percent,

resultingina“net”dividendreceivedbyforeigninvestors

equalto70percentofthe“gross”dividendavailableto

U.S.investors.

Thiswithholdingtaxalsoappliestofunddistributions

paidoutbyETFs.AllthreeoftheETFsinthisanalysis

payaquarterlydistribution,whichrepresentsthepass-

throughofdividendincomereceivedbythefundonthe

underlyingsharesheld.ThedividendyieldoftheS&P500

isapproximately2.15percent,whichimpliesanadditional

64.5bpsholdingcostperannumforforeignETFinvestors

duetothewithholdingtax.

11  FEBRUARY 2016  |  © CME GROUP

Futurescontracts,unlikeETFs,donotpaydividends.The

marketpriceofthefuturecontainsanimplieddividend

amount,whichgenerallycorrespondstothefullgross

dividendyieldontheunderlyingindex13.Thereisnofutures

equivalenttothedividendwithholdingtaxonETFshares.

Figure6showsholdingcostcomparisonforafully-funded

longposition(Scenario1)asexperiencedbyanon-U.S.

investorbasedona30percentwithholding.

Inthethree-monthperiodpriortothefirstdividend

ex-datethecomparisonisidenticaltoScenario1:the

lowertransactioncostsoffuturesmakethemacheaper

alternative.Justpriortothecross-overpointwhereETFs

becomemorecosteffective,the16.125bpsimpactofthe

withholdingtaxonthefirstquarterlydividendhitsthe

totalcostoftheETFcausingthejumpinthegreyline.As

aresult,thefutureisamorecosteffectivealternativeover

alltimehorizons.

Absentextremerichnessofthefuturesroll,ofan

approximate3mL+75bps,thecostadvantageof

futuresoverETFsforforeigninvestorswillholdtrue

inperiodsofrollrichnessandcheapnessmainly

becausethisisanadditionalholdingcostthatonlythe

ETFincurs.Overa12-monthholdingperiod,futures

at3mL+20bpswilldemonstrateacostadvantage

of52.6bps,andatthe3mL-5.7bpsfinancinglevel,

futureswillenjoya78.3bpsbenefit.

Figure 6: Foreign Investor (30% WHT), 12 months

(10)

0

10

20

30

40

50

60

70

80

Tota

l Cos

t (b

ps)

Holding Period

ES Futures (+0.20%) ES Futures (-0.06%) ETF, WHT 30%

Certaininternationalinvestorsareabletoreclaimsomeor

allofthedividendordistributionwithholdingtaxonETF

distributions.Apartialreclaimreducesthesizeofthe

“steps”inFigure6,whileatax-exemptforeigninvestor(i.e.

afullreclaim)iseconomicallyequivalenttoaU.S.investor

(Scenario1).

Fordividendrateslessthan95percentofgross(i.e.5

percentwithholding),thosefuturesoutlinedhereinaremore

costeffectiveacrossalltimehorizonsgiventhefuturesrich

scenarioof3mL+20bps.Giventheone-sidednatureof

dividedwithholdingtaxinthisanalysis,itisfairtodiscern

thatthereisavariablerelationshipbetweenthedegree

ofrichnessembeddedinfuturesandtheETFs’required

break-evenwithholdingrate.Iffuturesrichenedbeyond3mL

+20bps,aforeigninvestorcouldbewithheldgreaterthan5

percentonETFdividendpaymentsandstillbreakeven,albeit,

evenatmoderatelevelsofrichnessofthefuturesroll,itstill

requiresaveryhighreclaimratetoabatethewithholding

impactexactedonETFs.

13 The market price of a futures contract is a function of interest rates and anticipated future dividends. Deviations from fair value can be attributed to either component based on the investor’s assumptions. For example, the futures roll trading above fair value can be viewed as the result of above-market implied funding rates, a lower dividend assumption or a dividend withholding tax. The market standard is to attribute deviations to implied funding costs unless there is a known ambiguity around the timing or quantity of a particular dividend.

12  FEBRUARY 2016  |  © CME GROUP

UnlikeETFmanagementfees,whicharebeneficialtoshort

investors,thewithholdingcostonfunddistributionsdoes

notresultinoutperformanceforforeigninvestorslooking

totakeonshortexposure.Thestandardinthestockloan

marketisthattheborrowerofthesecuritypaysthefull

grossdividend.

Other considerations

Thisanalysishas,thusfar,focusedoncost.Thereare,

however,anumberofotherfactorsthatimpactinvestors’

productselectiondecisions.Forcompleteness,themore

salientconsiderationsareenumeratedhere.

Tax: E-miniS&P500futuresaresection1256contracts

withablendedU.S.capitalgainstreatmentof60percent

longtermand40percentshortterm,regardlessofholding

period,whichmayimprovetheafter-taxefficiencyof

futuresversusotheralternatives.

UCITS:Equityindexfuturesareeligibleinvestmentsfor

EuropeanUCITSfunds,whileU.S.-listedETFsarenot.

Currency: Theleverageinherentinafuturescontract

allowsnon-USDinvestorgreaterflexibilityinthe

managementoftheircurrencyexposuresascomparedto

fully-fundedproductslikeETFs.

Short Sale: Manyfundshavelimitations,eitherby

mandateorregulation,whichlimittheabilitytosellshort

securities.Thesefundsmay,however,beabletotakeon

shortexposureviaderivativessuchasfutures.(UCITS

fundshavesuchrestrictions.)Futuresarealsonotsubject

tolocaterequirements,RegulationSHOorRule201.

Fixed Versus Variable Dividends: Afuturescontractlocks

inafixeddividendamountatthetimeoftrade,while

ETFsaccruetheactualdividendstothefund’sNAVasand

whentheyoccur.

Product Structure: ETFsaremutualfunds,whilefuturesare

derivatives.Fundinvestmentmandatesandlocalregulations

maytreatthesestructuresdifferentlyandimposediffering

degreesofflexibilityintheirusagebythefundmanager.

Theassetmanagementcompany(ortheparticularfund

manager)mayalsohavepreferences.Somefundsmaylook

tolimittheiruseofderivativesandthereforeprefertheETF.

Alternately,managersmayprefernottouseaproductthat

paysamanagementfeetoanotherassetmanagerorhave

concernsaboutinvestors’perceptionsoftheiruseofother

issuers’fundsintheportfolio.

13  FEBRUARY 2016  |  © CME GROUP

CONCLUSION

Figure7summarizestheresultsoftheanalysis.Atthe

two-yearrollfinancingaverage(2013-2015)of3mL

+20bps,forallscenariosbutone,futuresprovidea

morecost-effectivevehicleforreplicatingS&P500

indexreturns.However,asdisplayedbytheH2-2015roll

financingaverage,atthesub-Liborlevelof3mL-5.7bps

futuresarethemostcost-effectiveproductchoicefor

replicatingS&P500indexreturns.Where,solongas

aninvestors’holdingperiodisfouryearsorfewer,and

futuresrollatorbelowacostof3mL+2.9bps,futureswill

alwaysbethebesttoolforaccessingtheS&P500forall

investors–eventhelong-termbuy-and-hold,

fully-fundedinvestor.

Figure 7: Summary of Results

Scenario

Cheapest Option

Roll is Cheap (Below 3-month USD Libor)

Roll is Rich (Above 3-month USD Libor)

Fully-Funded FuturesDepends on holding period and degree of richness

Leveraged(2x,8x)

Futures Futures

ShortSeller Futures Futures

International Futures Futures

Scenario: Fully-Funded, Roll Cost at a Premium to 3-month USD-Libor

Spread to 3-month USD-Libor

E-mini S&P 500 futures are more cost effective than ETFs for all investors when the Roll Cost trades at, or below, the following holding periods:

30 Days

60 Days

90 Days

180 Days

1 Year

2 Year

4 Year

+51 bps

+30 bps

+20 bps

+11 bps

+6.3 bps

+4.0 bps

+2.9 bps

Investorsareremindedthattheresultsinthisanalysisare

basedonthestatedassumptionsandgenerallyaccepted

pricingmethodologies.Theactualcostsincurredbyan

investorwilldependonthespecificcircumstancesofboth

theinvestorandtheparticulartradeincludingthetrade

size,timehorizon,brokerfees,executionmethodologyand

generalmarketconditionsatthetimeofthetrade,among

other.Investorsshouldalwaysperformtheirownanalysis.

FormoreinformationonCMEGroup’ssuiteofequityindex

futuresandoptionsonfutures,pleasecontactyourCME

Groupaccountmanagerorsalesrepresentative.

ForquestionsorcommentsaboutthisreportorCME

EquityIndexproducts,contactequities@cmegroup.com.

PM1304/00/0216

DistributedwithpermissionfromCMEGroup.

CMEGroup®isaregisteredtrademarkofChicagoMercantileExchangeInc.TheGlobelogo,CME,ChicagoMercantileExchange,Globex,CMEDirectandCMEDirectMessengeraretrademarksofChicagoMercantileExchangeInc.ChicagoBoardofTradeisatrademarkoftheBoardofTradeoftheCityofChicago,Inc.NYMEXisatrademarkoftheNewYorkMercantileExchange,Inc.Standard&Poor’sandS&P500®aretrademarksofTheMcGraw-HillCompanies,Inc.andhavebeenlicensedforusebyChicagoMercantileExchangeInc.

Futurestradingisnotsuitableforallinvestors,andinvolvestheriskofloss.Futuresarealeveragedinvestment,andbecauseonlyapercentageofacontract’svalueisrequiredtotrade,itispossibletolosemorethantheamountofmoneydepositedforafuturesposition.Therefore,tradersshouldonlyusefundsthattheycanaffordtolosewithoutaffectingtheirlifestyles.Andonlyaportionofthosefundsshouldbedevotedtoanyonetradebecausetheycannotexpecttoprofitoneverytrade.Allexamplesinthisbrochurearehypotheticalsituations,usedforexplanationpurposesonly,andshouldnotbeconsideredinvestmentadviceortheresultsofactualmarketexperience.

TheinformationwithinthisbrochurehasbeencompiledbyCMEGroupforgeneralpurposesonlyandhasnottakenintoaccountthespecificsituationsofanyrecipientsofthisbrochure.CMEGroupassumesnoresponsibilityforanyerrorsoromissions.AllmatterspertainingtorulesandspecificationshereinaremadesubjecttoandaresupersededbyofficialCME,NYMEXandCBOTrules.CurrentCME/CBOT/NYMEXrulesshouldbeconsultedinallcasesbeforetakinganyaction.

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