Beyond Futures: Why Consider ETFs?
The benefits of transparency, lower costs, and increased intra-day trading capabilities mean exchange traded funds (ETFs) have become a significant component of institutional investors’ beta replication strategy. In contrast, the futures market faces headwinds due to the increased operational and capital requirements for banks. We explore these two vehicles and provide a comparison of structure, pricing, transparency and liquidity, and efficiency.
Equity index futures are standardised cash-settled forward contracts. These derivatives require only a small fraction of the notional contract value up-front, in the form of margin, set by the listing exchange. Index futures are expiring contracts, listed on a quarterly schedule with the near month contract typically offering the most liquidity.
An ETF is a pooled investment vehicle, which by design is a fully funded instrument. Shares of an ETF represent undivided ownership of the underlying assets managed by the issuer. The ETF’s management expense ratio (MER) is typically the most important determinant of holding cost.
From an operational perspective, the futures contracts expiring structure and the ETFs open-ended structure are a clear fundamental difference.
For investors using futures to obtain longer term beta exposure, regular rolling of future contracts from one contract to the next is required as they expire. In contrast, ETFs have no set maturity, and beyond the reinvesting of dividends (in cases where the ETF distributes income, rather than reinvesting it), there is limited ongoing maintenance required.
While liquid futures contracts are typically only available on a limited number of equity indices, ETFs now offer liquid access to a wider range of targeted exposures.
ETFs represent pro-rata physical ownership of assets while futures are derivatives. So, while seeking the same replication, ETFs and index futures will present structural, operational, and regulatory differences important to the vehicle selection process.
Since an index futures contract represents an unfunded forward transaction, the futures market price must represent applicable costs incurred while holding the asset over the life of the contract. This cost of carry consists of the financing rate for the forward transaction less expected dividends through contract expiration. While dividend forecast accuracy is a component of futures price risk, the primary consideration should be the financing rate.
A deviation in the futures market price from fair valueis referred to as contract mispricing. This difference reflects varying rates between implied contract financing and the benchmark - the 3-month AUD Bank Bill Swap Rate, or BBSW A futures contract price is considered rich to fair value when implied financing exceeds BBSW; conversely, the futures contract price is considered cheap when implied financing is sub-BBSW.
On the other hand, ETFs represent ownership of assets being managed by the provider (and disclosed daily) on behalf of the fund. As a result, the underlying net asset values (NAV) for ETFs generally involve more straightforward estimations.
An ETF’s market price may trade at a premium or discount to its NAV, but this difference is typically temporary as market participants arbitrage any difference between ETF price and NAV. For ETFs with underlying securities that are closed or inaccessible during local market hours, premiums or discounts in ETF market price versus NAV can represent price discovery of its underlying constituents.
For index futures, performance disparity is primarily attributable to three factors: roll mispricing, funding disparity and dividend forecast error. As investment horizon extends beyond contract expiry, the rolling of futures contracts will be subject to mispricing between contracts. The ability to forecast holding costs becomes increasingly difficult as time extends androlls are incurred.
For fully funded investors, the implied financing rate represents the required rate of return on cash. Any differential is considered the funding disparity and will influence total return performance.
For ETFs, the evaluation of cost is a relatively straight forward process. The primary cost of ownership is constant and explicitly defined in the MER. Other factors thatmay influence the performance of an ETF relative to the index are transaction and rebalancing costs, cash drag, and securities lending of constituents.
The tracking difference (the difference between actual market performance of an ETF and the underlying index) depicts the efficiency of a fund to track the underlying index net of expenses and other aforementioned factors over a given investment period.
In the futures market, for every long position, there is a counter-party short position. Demand for long positions generally exceeds demand for short positions. Dealers, typically investment banks, step in to supply short positions; and when short demand exceeds long positions, dealers step in to buy contracts. Dealers can then buy or sell the underlying cash index alongside these positions and aim to earn a return in excess of their cost of capital through cash-and-carry arbitrage.
There are many factors that can contribute to supply and demand imbalances for futures, such as liquidity pressure. Futures contract pricing will ultimately reflect the ability of market participants to fund the synthetic replication of the index at a given point in time.
But since the global financial crisis of 2008, regulatory reforms have increased operational and capital requirements for banks —constraining traditional liquidity providers offutures markets and impacting the traditional forces of supply and demand. This has led to greater variability in financing rates relative to the benchmark.
In contrast, the ETF market has continued to develop from a liquidity perspective. Persistent growth in assets and investor type has also led to consistent improvement in ETF product efficiency.
With clear structural differences from a pricing and cost perspective, total return performance of index ETFs and futures on a fully funded basis will inevitably vary based on market conditions. When evaluating the total cost of ownership and pricing efficiency of both vehicles, beta replication via ETFs has drawn significant institutional interest for its transparency relative to index futures.
As investment horizon extends, cost forecasting becomes increasingly difficult and the benefits of transparency increase. As financial markets continue to evolve around regulatory reform, investment vehicles can react uniquely to changing market dynamics.
Given recent trends in supply and demand of futures markets, the cost stability and transparency of ETFs has become a defining competitive advantage relative to futures on a fully funded basis.
The use of ETFs for cash equitisation is popular with overseas asset managers, but Australian investors generally prefer using futures as a cash equitisation tool. But using ETFs for all or part of a cash equitisation program is likely to enhance returns and provide better after-tax outcomes.
Derivative investments may involve risks such as potential illiquidity of the markets and additional risk of loss of principal. Investing in futures is highly risky. Futures positions are considered highly leveraged because the initial margins are significantly smaller than the cash value of the contracts. The smaller the value of the margin in comparison to the cash values of the futures contract, the higher the leverage. There are a number of risks associated with futures investing including but not limited to counterparty credit risk, basis risk, currency risk, derivatives risk, foreign issuer exposure risk, sector concentration risk, leveraging and liquidity risks.