the big picture: a cost comparison of futures and etfs

The Big Picture: A Cost Comparison of Futures and ETFs

How the world advances

1TOTAL COST ANALYSIS | MARCH 2015 | © CME GROUP

EXECUTIVE SUMMARY

• Thisreportcomparestheall-incostofreplicatingtheS&P500totalreturnviaequityindexfutures

andexchange-tradedfunds(ETFs)acrossavarietyofdifferentusecasesandtimehorizons.

• ThespecificproductsusedintheanalysisaretheCMEE-miniS&P500futureandthethree

US-listedS&P500ETFs:theSPDRSPY,iSharesIVVandVanguardVOO.

• Theanalysisbeginswithadetailedlookatthecomponentsoftotalcostandtheassumptionsthat

underliethecalculations.Thisincludesobservationsaboutrecentchangesintheimpliedfinancing

ratesoffuturesandthedriversofthesemoves.

• Thetotalcostofindexreplicationacrossarangeoftimehorizonsiscalculatedforfourcommon

investmentscenarios:afully-fundedlongposition,aleveragedlong,ashortpositionanda

non-USinvestor.

• ThechoicebetweenfuturesandETFsisnotaneither-ordecision.E-miniS&P500futuresare

showntobemorecost-effectivethanS&P500ETFsforleveraged,shortandnon-USinvestors

acrossalltimehorizons.

• Forfully-fundedinvestors,theoptimalchoicedependsontimehorizon.Investorswithholding

periodsuptofourmonthsarebetterservedbyfutures,whileforlongerholdingperiods,ETFsare

preferablewiththeVOOthemostcostefficientalternative.

Scenario

Cheapest Option

Short Term (<3m) Long Term (>3m)

Fully-Funded Futures ETFs

Leveraged(2x,8x) Futures Futures

ShortSeller Futures Futures

International Futures Futures


INTRODUCTION

Thisreportcomparestheall-incostofreplicatingtheS&P

500totalreturn1viaequityindexfuturesandETFs.

Giventhediversityofclientsandpotentialusesforboth

ETFsandfutures,thereisno“one-size-fits-all”answerto

thequestionofwhichismorecostefficient.Theoptimal

choicedependsonthedetailsofboththeclientandthe

specifictrade.

Theapproachisthereforetoconsiderfourcommon

investmentscenarios–afully-fundedlongposition,a

leveragedlong,ashortpositionandanon-USinvestor–

andcomparethecostsofindexreplicationwithfutures

andETFsineach.Whilethesescenariosdonotrepresent

allpossibleapplicationsforeitherproduct,theycover

themajorityofusecasesandanalysisofthescenarios

providesinsightsintofactorsthatinvestorsshould

considerwhenmakingtheirimplementationdecisions.

ThisanalysiscomparestheCMEE-miniS&P500future

(ticker:ES)withthethreeUS-listedS&P500ETFs:SPDR

S&P500ETF(SPY),iSharesCoreS&P500ETF(IVV)and

VanguardS&P500ETF(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 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 (0.25 bps) 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% 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.


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’s own analysis,

the market impact of the hypothetical $100m 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 291.6 161,843

SPY 194.7 21,113

IVV 70.7 824

VOO 30.43 232

Fullyear2014ADVaverages.AuM/OIasof18Feb,2015.Source:CMEandBloomberg

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 $162 billion

(2014 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 8x that

of the SPY and more than 150x 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.ETFmanagementfeeswhichaccruedaily)although

therearesome,whicharediscretebutrecurring(e.g.

executionfeesonquarterlyfuturesrolls).

ThesourcesofholdingcostsforETFsandfuturesare

different,owingtotheverydifferentstructuresofthe

twoproducts.

ETFs: TheholdingcostofanETFisthemanagementfee

chargedbythefundfortheserviceofreplicatingtheindex

return(generallythroughthepurchaseandmaintenance

oftheunderlyingstockportfolio).Themanagementfee

forthethreeETFsinouranalysisrangesbetween5.0and

9.45bpsperannum.

Asecondpotentialsourceofholdingcostwouldbetracking

errorbetweenthefund’sreturnsandthoseoftheindex

(otherthanthoseduetotheapplicationofthemanagement

fee).Thisriskwillbeignoredintheanalysisthatfollows,

asithasneverbeenanissuewiththeETFsunder

considerationandassuch,thereisverylimitedbasisfor

estimatingthemagnitudeorimpactofpotentialdeviations.

Futures:Futurescontractsarederivativesandprovide

leverage.UnlikeanETF,wherethefullnotionalamount

ispaidbythebuyertothesellerattradeinitiation,with

futurescontractsnomoneychangeshandsbetweenthe

parties.Rather,bothbuyerandsellerdepositmarginof

approximately5%4ofthenotionalofthetradewiththe

clearinghousetoguaranteetheirobligationsunder

thecontract.

AscomparedwiththeETFmanagementfee,buyersof

futurescontractsareimplicitlypayingthesellersnotonly

toreplicatetheindexreturns,butalsotodosowiththeir

3 The VOO ETF is a share class of Vanguard’s unlisted S&P 500 Index Fund which has $195.8 billion in AuM.

4 At time of writing the margin requirement on E-mini S&P futures is $4,600 on a contract notional of roughly $100,000. Margin amounts are subject to change.


ownmoney.Asaresult,thepriceofafuturescontract

containsacomponentthatrepresentstheinterest

chargesonthese“borrowed”funds5.

Giventhetradingpriceofthefutures,onecaninfer

theratethatthemarketisimplicitlychargingonthese

“borrowed”funds.Whilethisfundingcostisimpliedin

allfuturestransactions,itismostreadilyinferredfrom

tradinginthefuturesrollandfrequentlyreferredtoasthe

“rollcost”.

Comparingthisimpliedinterestratewiththecorresponding

USDLiborrateoverthesameperiod,onecancalculatethe

spreadtoLibor,anddeterminewhetherthefutureisrolling

“rich”(impliedfundingaboveLibor,positivespread)or

“cheap”(impliedfinancingbelowLibor,negativespread).

Forafully-fundedinvestor(i.e.onethathascashequal

tothefullnotionalvalueoftheposition),therichnessor

cheapnessoftherollisnotmerelya“theoretical”costbut

theactualholdingcostforindexreplicationviafutures.

Theinvestorrealizesthiscostbybuyingthefutures

contractsandholdinghisunusedcashinaninterest-

bearingdeposit.Throughthefuturescontractshepays

theimpliedfinancingrateonthefullnotionalofthetrade,

whileontheunusedcashondeposithereceivesarateof

interest,whichweassumetobeequalto3mLibor6.The

differencebetweentheinterestpaidandinterestearned

istheholdingcostofthepositionandisequaltothe

richnessorcheapnessoftheroll.

Observations on the Futures Roll

Unlikeamanagementfee,theimpliedfinancingcostof

thequarterlyfuturesrollisnotconstantbutdetermined

bytheforcesofsupplyanddemandandarbitrage

opportunitiesinthemarket.

Historically,theimpliedspreadtoLiborofESfutureswas

belowthelowestmanagementfeesonanyETF.Overthe

10yearperiodbetween2002and2012,theESfuturesroll

averaged2bpsbelowfairvalue7.

Since2012,thepricingoftherollhasbecomemorevolatile

andtradedathigherlevelsasshowninFigure1,withthe

richnessaveraging35bpsin2013and26bpsin2014.

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(andmorevolatile)the

impliedfundingcostswillbe.

ThepersistentlystrongS&P500returnsoverthelast

threeyears–averaging20.3%annualgrowthsincethe

startof2012–hascausedadecreaseinthesizeofthe

naturalshortbaseasinvestorsreduceshortsandbias

theirpositionstowardslongexposure.Thishasincreased

thedemandonliquidityproviders–especiallyU.S.banks

–tomeettheexcessdemand.

Beginningin2013,however,changesinbanksector

regulationhaveincreasedthecapitalandliquidity

requirementsforbanks,makingitmoreexpensivefor

themtofacilitatefuturesbuyers.Theresulthasbeena

higherimpliedfinancingcostinthefuturesrolls.

5 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.

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

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


Figure 1: Roll Richness with High/Low Range8

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Source: CME

Itisunlikelythateitherofthesefactorsrepresent

permanentshiftsinthemarket.In2014therollmarket

begantorenormalizewiththeMar,JunandSeprolls

averagingjust17bps(lessthanhalftheDec2012–Dec

2013level)andtradingaslowas7bpsinSep9.The

subsequentrichnessoftheDec2014rollindicatesthat

someyear-endeffectsremain.However,therehavealready

beenindicationsthattheopportunitytocaptureabove-

marketfinancingratesisattractingnewparticipantstothe

equityfuturesmarket,whichwillinturndriveyieldslower.

Asforthereductioninthenaturalshortbase,thisis

primarilyafunctionofthelow-volatilitygrindhigherin

equitymarketswhichcannotcontinueindefinitely.An

increaseinvolatilityoranequitymarketcorrectionwill

leadtoanincreaseinnaturalshortpositions.

Intheanalysisthatfollows,E-miniS&P500futuresare

assumedtoroll20bpsabove3-monthUSDLibor.

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

SPY 1.25 2.00 9.45

IVV 1.25 2.50 7.0

VOO 1.25 2.50 5.0

SCENARIO ANALYSIS

Havingestablishedbaselinetransactionandholdingcost

estimates,itisnowpossibletocomputethetotalcost

ofindexreplicationviafuturesandETFsforvarioususe

cases.Thisreportwillconsiderfourscenarios:afully-

fundedinvestor,aleveragedinvestor,ashortsellerandan

internationalinvestor(i.e.non-USdomicile).Ineachcase,

totalcostiscomputedforallholdingperiodsupto

12months.

Allscenariosassumethesametransactioncostsand

recognizetheround-tripfeesandmarketimpactat

tradeinitiation.Futuresrollcostsareassessedonthe

Wednesdaybeforeeachquarterlyexpiry.

Whileitisnotspecificallymentionedinexplanationsof

eachscenario,allfuturescarrycalculationshavebeen

adjustedforthemargindepositedwiththeCMEclearing

house,whichdoesnotearninterest.Atcurrentinterest

ratestheimpactisapproximately1.3bps/annum.

8 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.

9 Source: CME Equity Quarterly Roll Analyzer tool


Scenario 1: Fully-funded Investor

Forthefully-fundedinvestor,thetotalcostofindex

replicationoveragivenperiodisthesumofthetransaction

costsplusthepro-rataportionoftheannualholdingcosts.

Figure2showsthecostofindexreplicationviaindex

futuresandETFsfortimehorizonsouttosixmonths

assuminganinitialtradeexecutiononJanuary2,2015and

thetransactionandholdingcostestimatesinTable2.

Figure 2: Fully-funded Investor, 6 months

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Holding Period

Futures SPY IVV VOO

Thestartingpointforeachgraph(theintersectionwiththe

verticalaxis)representstheround-tripexecutioncost,

rangingfrom2.9bpsforfuturestobetween6.5and7.5bps

forETFs.Thelinesslopeupwardastimepasses,reflecting

thegradualaccrualoftheannualholdingcosts,withsmall

jumpsinthefutureslineduetothecostofquarterly

futuresrolls.Becausetheannualmanagementfeesonthe

ETFsarebelowtheimpliedrichnessofthefutures,the

graphsoftheETFsslopeupwardmoreslowlythanthatof

thefutures.

Forshortholdingperiods,thehighertransactioncostsof

theETFsmakethefuturesmoreeconomicallyattractive

(futureslinebelowallthreeETFlines).Thismakesfutures

aparticularlyattractivetoolformoreactive,tactical

andshort-termtraders.Forlonger-termholders,the

cumulativeeffectsofhigherimpliedfinancingmakethe

ETFamoreefficientalternative.

ThebreakevenpointatwhichETFsbecomeamore

economicallyefficientalternativeoccursinthefourth

month.Inthisspecificexample,theVOObreakevenarrives

firstonApril3(91days),followedtheSPYonApril7

(95days)andtheIVVonApril16(104days).

Extendingtheanalysisouttoa12-monthholdingperiod,

onecanseethatETFsarecheaperthanfuturesby

between10.2and13.7bps.Theseresultsareconsistent

withrecentanalysispublishedbysell-sidebanks10.

Figure 3: Fully-funded Investor, 12 months

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Holding Period

Futures (20bps) Futures (10bps) SPY IVV VOO

Figure3showshowa10bpsrenormalizationofthe

futuresimpliedfundingratefrom20bpsto10bps(the

dottedline)impactsthesebreakevenpoints.Inthismore

normalfuturesenvironmentthebreakevenpointsmove

outseveralmonths.TheVOOisstillthefirst,crossingon

July29(208days).TheIVVcrossestwomonthslateron

September23(263days)andtheSPYafurthertwo

monthsonDecember15(347days).The12-monthcost

advantageofETFsinthisscenariorangesfrom0.2to

3.7bps.

10 BNP Paribas: “Accessing Efficient Beta: ETFs vs. Futures”, October 2014; Bank of America Merrill Lynch, “Cost Comparison of Equity Futures, ETFs and Swaps”, 22 April, 2014.


Scenario 2: Leveraged Investor

Equityindexfuturesareleveragedinstruments.The

investorpostslessthan5%margintotheexchange,

whichresultsinover20xleverageontheirposition.The

threeETFsinthisanalysisarenotleveraged11butmaybe

purchasedonmarginbyinvestorswhodesireleverage.

Thedifferenceisthequantityofleveragethatispossible.

UnderFederalReserveBoardRegulationsTandU,there

arelimitsontheamountabrokermaylendtoaninvestor

wishingtopurchasesecuritiesonmargin.

UnderRegT,themaximumamountthatcanbelentis

50%ofthepurchaseprice,resultinginamaximumof2x

leverage.Moresophisticatedinvestorsmaybeeligiblefor

portfoliomarginingthroughaprimebrokerunderwhich

theycouldpotentiallyachieve6-8xleverageunderRegU.

Greaterthan8xleverageisnotpossible.

ToderiveaholdingcostfortheleveragedETFposition,

standardprimebrokerlendingratesforaninstitutional

clientof3mLibor+40bpsareassumed.

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$50millionalreadyhasmorethan10x

therequiredmargindeposit.Rather,itisacaseofleaving

lessmoneyondeposit.Inthefully-fundedcaseitwas

assumedthattheinvestorearned3mLiboronthe$100

millionleftondeposit.Inthe2xleveragedcase,theamount

ofdepositedcashisreducedby$50million.Thiscanbe

viewedequivalentlyastheinvestordepositingthefull$100

millionandthenpaying backtheinterestearnedon$50

million.Viewedthisway,theholdingcostofthe2xleveraged

scenarioforfuturesisidenticaltothefully-fundedscenario

plustheinterestexpenseon$50millionat3mLibor.

Figure 4: Total Cost for 2x and 8x Leverage, 12 months12

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Holding Period

Futures 2x Futures 8x ETF 2x ETF 8x

ThedashedlinesinFigure4showthetotalcostofindex

replicationona2xleveredbasisforholdingperiodsupto

12months.

Comparedtothefully-fundedscenarioinFigures2and3,

thetotalcosthasincreasedforbothpositions.However,

duetoabove-Liborrateschargedonborrowedfundsbya

primebroker,theETFholdingcosthasincreasedby20bps

perannummorethanthefutures(40bpsspreadonone

halfofthetradenotional).Asaresult,futuresarethemore

economicaloptionacrossalltimehorizons.

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

12 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.


Eight-times Leveraged Investor

Theanalysisforthe8xleveragedcaseproceedsina

similarfashion.Inthiscase,theinvestorhas$12.5million

ofcashwithwhichtoobtain$100millionofexposure.

TheETFinvestorthereforehasan$87.5millionloanfrom

theprimebrokerwhilethefuturesinvestorhasan$87.5

millionreductionintheirdeposit.

ThesolidlinesinFigure4showthecostcomparisonfor

the8xleveredcase.Astheamountoffundsborrowed

increases,theincrementalborrowingcostofaprime-

brokerfundedETFpositionincreases,ascomparedwith

theintrinsicleverageoffutures.Inthe8xleveredcase,the

40bpsfundingdifferentialon87.5%ofthenotionalofthe

traderesultsina35bpsgreaterincreaseintheholdingcost

ofETFsrelativetofutures.

ThecostadvantageoffuturesoverETFsforaoneyear

holdingperiodis8.2and23.1bpsforthe2xand8x

leveragedcases,respectively.

Thisanalysishasbeenconductedusingcurrent3mLibor

ratesofapproximately0.25%.Asinterestratesrise,the

absolutecostofleveragedexposurewillincreaseforboth

products.However,thedifferencebetweentheholdingcosts

ofETFsandfuturesisnotafunctionoftheabsoluteratebut

ofthespreadbetweencashondepositandborrowedcash

andpersistsacrossdifferentinterestrateregimes.

Scenario 3: Short investor

Ashortpositionprovidesnegativemarketexposureandis

inherentlyleveraged.

WithETFs,theleveragecomesintheformofaloanof

sharestosellshortbyaprimebroker.Thesaleofthe

borrowedsharesraisescash,whichremainsondeposit

withtheprimebroker.Theshortsellerpaysabpsper

annumfeetothelenderoftheETFwhichisdeductedfrom

theinterestpaidonthecashraisedbythesale.

Atypicalprimebrokerborrowfeeof40bpsperannum

isassumed,resultinginareturnoncashraisedof

3mLibor–40bps13.

Inadditiontothecashraisedfromtheshortsale,the

investormustpostanadditional50%ofthenotionalof

thetradeincashtothebrokerasmargin14.Theadditional

fundspostedtotheprimebrokerwillbeassumedtoearn

3mLibor.

Becausetheyareusingderivatives,theshortseller

offuturesdoesnotneedtoborrowsharesorpaythe

associatedfee.Thesaleofafuturescontractisidentical

tothepurchase,withthesamemarginpostedwiththe

clearinghouse.

Whenanalyzingtheeconomicsofashortpositionitis

importanttorememberthattheholdingcostsforthelong

investorbecomebenefitsfortheshort.ETFmanagement

feescauseasystematicunderperformancerelativetothe

benchmarkwhich,fortheshortinvestor,representsan

excessreturn.Therichnessofthefuturesrollprovidesa

similarbenefitforfuturesinvestors.

TheholdingcostsforshortpositionsinfuturesandETFs

canbedecomposedasfollows:

Futures:

1) Receivefutures’impliedfundingrateof3mLibor+

20bpsonthe$100million

2) Receive3mLiboron$50millioncash

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

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


ETFs:

1) Receivethemanagementfeeof5-9.45bps

2) Receive3mLibor–40bpson$100millionraised

fromtheshortsale

3) Receive3mLiboronthe$50milliondepositedwith

theprimebroker.

Figure5showsthatinbothcasestheholdingcostsare

negative–overtime,theinvestor’srelativeperformance

versustheshortreturnofthebenchmarkimproves,as

demonstratedbythedownwardslopeoftheline.

However,duetothecombinationofhigherETFtransaction

costsandthefundingspreadschargedbyprimebrokers,

thefuturesprovideamorecost-effectiveimplementation

acrossalltimehorizons.

ThecostadvantageoffuturesoverETFsfora

12-monthholdingperiodis53.6bps.

Figure 5: Short Futures vs. ETF, 12 months

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Holding Period Short Future Short ETF

Scenario 4: International

CME does not provide tax advice. Investors should consult

their own advisors before making any investment decision.

Ingeneral,foreigninvestorsintheUSequitymarketare

subjecttoawithholdingtaxondividendpaymentsbyUS

corporations.Thebasewithholdingrateis30%,resulting

ina“net”dividendreceivedbyforeigninvestorsequalto

70%ofthe“gross”dividendavailabletoUSinvestors.

Thiswithholdingtaxalsoappliestofunddistributions

paidoutbyETFs.AllthreeoftheETFsinthisanalysis

payaquarterlydistributionwhichrepresentsthepass-

throughofdividendincomereceivedbythefundonthe

underlyingsharesheld.ThedividendyieldoftheS&P500

isapproximately2.0%,whichimpliesa60bpsadditional

holdingcostperannumforforeignETFinvestorsdueto

thewithholdingtax.

Futurescontracts,unlikeETFs,donotpaydividends.The

marketpriceofthefuturecontainsanimplieddividend

amountwhichgenerallycorrespondstothefullgross

dividendyieldontheunderlyingindex15.Thereisnofutures

equivalenttothedividendwithholdingtaxonshares.

Figure6showsholdingcostcomparisonforafully-funded

longposition(Scenario1)asexperiencedbyanon-US

investorbasedona30%withholding.

Inthe3-monthperiodpriortothefirstdividendex-date

thecomparisonisidenticaltoScenario1:thelower

transactioncostsoffuturesmakethemacheaper

alternative.Justpriortothecross-overpointwhereETFs

becomemorecosteffective,the15bpsimpactofthe

withholdingtaxonthefirstquarterlydividendhitsthe

totalcostoftheETFcausingthejumpintheredline.Asa

result,thefutureisamorecosteffectivealternativeover

alltimehorizons.

15 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.


ThecostadvantageoffuturesoverETFsfora

12-monthholdingperiodis48.3bps.

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

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l Cos

t (b

ps)

Holding Period

Foreign Holder Futures Foreign Holder US ETF

Certaininternationalinvestorsareabletoreclaimsomeor

allofthedividend/distributionwithholdingtaxonETF

distributions.Apartialreclaimreducesthesizeofthe

“steps”inFigure6whileatax-exemptforeigninvestor(i.e.

afullreclaim)iseconomicallyequivalenttoaUSinvestor

(Scenario1).

Fordividendrateslessthan92%ofgross(i.e.8%

withholding),futuresaremorecosteffectiveacrossall

timehorizons.

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.capitalgainstreatmentof60%long

termand40%shortterm,regardlessofholdingperiod,

whichmayimprovetheafter-taxefficiencyoffutures

versusotheralternatives.

UCITS:Equityindexfuturesareeligibleinvestmentsfor

EuropeanUCITSfunds,whileUS-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: ETFsaremutualfundswhilefuturesare

derivatives.Fundinvestmentmandatesandlocalregulations

maytreatthesestructuresdifferentlyandimposediffering

degreesofflexibilityintheirusagebythefundmanager.

Theassetmanagementcompany(ortheparticularfund

manager)mayalsohavepreferences.Somefundsmaylook

tolimittheiruseofderivativesandthereforeprefertheETF.

Alternately,managersmayprefernottouseaproductwhich

paysamanagementfeetoanotherassetmanagerorhave

concernsaboutinvestors’perceptionsoftheiruseofother

issuers’fundsintheportfolio.


CONCLUSION

Figure7summarizestheresultsoftheanalysis.Forall

scenariosbutone,futuresprovideamorecost-effective

vehicleforreplicatingS&P500indexreturns.

Figure 7: Summary of Results

Scenario

Cheapest Option

Short Term (<3m)

Long Term (>3m)

Fully-Funded Futures ETFs

Leveraged(2x,8x) Futures Futures

ShortSeller Futures Futures

International Futures Futures

Theexceptionisthatofafully-fundedUSinvestor(or

tax-exemptforeigninvestor)withalongtime-horizon,

wheretherecentrichnessoftheESrollhasincreasedthe

costoffuturesrelativetoETFs.WithS&P500impliedand

realizedvolatilityhigherin2015thanatalmostanypoint

inthelasttwoyears,itremainstobeseenhowlongthis

situationcanpersist.

Investorsareremindedthattheresultsinthisanalysisare

basedonthestatedassumptionsandgenerallyaccepted

pricingmethodologies.Theactualcostsincurredbyan

investorwilldependonthespecificcircumstancesofboth

theinvestorandtheparticulartradeincludingthetrade

size,timehorizon,brokerfees,executionmethodologyand

generalmarketconditionsatthetimeofthetrade,among

other.Investorsshouldalwaysperformtheirownanalysis.

FormoreinformationonCMEGroup’ssuiteofequityindex

futuresandoptionsonfutures,pleasecontactyourCME

Groupaccountmanagerorsalesrepresentative.

ForquestionsorcommentsaboutthisreportorCME

EquityIndexproducts,[email protected].

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

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the big picture: a cost comparison of futures and etfs

Economy & Finance

cost comparison of futures

equity index futures

emini futures

component of transaction

execution costs

time horizon

broker intermediary

total return