ETFs vs. futures: What’s the difference?

What’s driving the increased adoption of ETFs over futures? Comparing the structure, cost, and efficiency of these vehicles holds the answer.

Over the years, ETFs have become a larger component of institutional investors’ beta replication strategy due to asset growth, transparency, lower costs, and increased intra-day trading capabilities. At the same time, financial regulatory reforms have increased operational and capital requirements for banks—constraining traditional liquidity providers of futures markets. The increased adoption of exchange traded funds (ETFs) and changes to futures market dynamics have inevitably led to comparisons of structure, cost, and efficiency between vehicles that highlight what’s driving investor interest toward ETFs.

How the structures of ETFs and futures differ

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 total expense ratio (TER) is typically the most important determinant of holding cost.

Equity index futures are standardized cash-settled forward contracts. Simply put, they are standardized agreements to buy or sell an underlying asset at a predetermined price and date and 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.

From an operational perspective, the ETF’s open-ended structure and the futures contract’s expiring structure is 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 re-investing of dividends (in cases where the ETF distributes income, rather than re-investing it), limited ongoing maintenance is required.

It’s important to emphasize that ETFs represent pro rata physical ownership of assets and futures are derivatives. Therefore, while seeking the same replication, ETFs and index figures will present structural, operational, and regulatory differences important to the vehicle selection process (Figure 1).

Three functional differences between futures and ETFs

Pricing mechanics

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, or the “cost of carry.”

The basic cost of carry calculation 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 value is referred to as contract “mispricing.” This difference reflects varying rates between implied contract financing and the benchmark.

The prevailing benchmark for financing in the futures market is the Secured Overnight Financing Rate (SOFR)). The futures contract price is considered “rich” to fair value when implied financing exceeds SOFR. Conversely, the futures contract price is considered “cheap” when implied financing is sub-SOFR. This cost measure is the frequently cited benchmark evaluation of the market price of an index futures contract.

In contrast, 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—particularly for funds with publicly listed equities during US market hours.

At times, an ETF’s market price may trade at a premium or discount to its net asset value (NAV). This difference is typically temporary as market participants arbitrage any difference between the ETF’s price and NAV.

For ETFs with underlying securities that are closed or inaccessible during US market hours, premiums or discounts in ETF market price versus NAV can represent “price discovery” of its underlying constituents.

Cost transparency

For index futures, performance disparity is primarily attributable to three factors:

• Roll mispricing 
• Funding disparity 
• Dividend forecast error

When evaluating the holding costs of index futures on an ex-ante basis, roll mispricing and funding disparity are the primary focus for a fully-funded investor.

As investment horizon extends beyond contract expiry, the rolling of futures contracts will be subject to mispricing between contracts. Each roll requires independent evaluation as implicit financing rates between contracts determines whether the roll is “rich” or “cheap.” The ability to forecast holding costs becomes increasingly difficult as time extends and rolls are incurred.

For fully-funded investors, the implied financing rate reflects the effective cost of financing the full notional value of the futures contract. It’s derived from the difference between the spot interest rate and the rate implied by the futures delivery date. Any difference between the two represents a funding disparity that directly impacts total returns. As a result, cash investment alternatives should be evaluated relative to the futures-implied financing rate, not only against the benchmark SOFR rate.

For ETFs, the evaluation of cost is a relatively straightforward process. The primary cost of ownership is constant and explicitly defined in the TER. Other factors that may influence performance of an ETF relative to the index are transaction and rebalancing costs, cash drag (funds that don’t reinvest dividends), and securities lending of constituents.

The difference between actual market performance of an ETF and the underlying index is called “tracking difference.” This value depicts the efficiency of a fund to track the underlying index net of expenses and other aforementioned factors over a given investment period. 

Cost variability

How do differing pricing and cost drivers for each vehicle contribute to performance disparity during varying market intervals?

For every long position in the futures market, there is a counter-party short position. Demand for long positions of most key index futures in the investment community generally exceeds that of short positions. Dealers in the futures markets, typically investment banks, step in to supply short positions and quell demand. Conversely, in cases in which short demand exceeds long positions, dealers can step in to buy contracts. In its simplest form, dealers can then buy or sell the underlying cash index alongside these positions respectively, 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 index futures—such as liquidity pressure or prolonged one-sided markets—subsequently intensifying funding pressure for liquidity providers reflected in higher or lower implied financing rates. 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.

Since the Global Financial Crisis of 2008, many dealer banks have been subject to considerable regulatory reforms. In particular, the Dodd-Frank Act introduced comprehensive regulations governing derivative products including futures. Additionally, mandatory capital requirements under Basel III have constrained balance sheets and subsequently increased cost of capital.

Since banks have traditionally served an important role as liquidity providers and arbitrageurs in futures markets, these structural reforms have affected the traditional forces of supply and demand.

In contrast, ETF pricing has exhibited far less structural variability. Continued growth in assets, trading volume, and authorized participant participation has deepened secondary market liquidity and strengthened the arbitrage mechanism that anchors ETF prices to net asset value.

And because ETFs rely on in kind creation and redemption rather than dealer balance sheet intermediation, their costs are less sensitive to fluctuations in funding conditions. As a result, ETFs tend to deliver more stable and transparent implementation costs across market regimes, allowing investors better oversight into tracking difference relative to the underlying index.

Implementation considerations for ETFs and futures

When comparing vehicles, the total cost of ownership, holding period, and the cost to implement each position in the secondary market should all be considered. These costs are typically comprised of applicable commissions as well as market impact, or the extent to which price moves unfavorably during implementation. Market impact costs will depend on a variety of factors including trade size, product selection, and execution method.

The liquidity of index replication vehicles will ultimately depend on the underlying basket of equities. However, ETFs and futures contracts for the same index are often considered additive from a liquidity perspective as liquidity providers and arbitragers from varying markets source different products for hedging. Therefore, material differences in implementation cost of like-index products should not persist.

When selecting the most appropriate ETF, investors must take into account all measures of cost including transaction costs, expense ratio and market spreads. If an ETF has low trading volume and a history of variable trading costs, especially during periods of stress, then any cost savings from a lower expense ratio could be negated by higher trading costs. As investors using futures are accustomed to significant market depth, anything less than that may be inadequate for investors trading in size and looking to minimize market impact.

Cost stability and transparency give ETFs an edge

With 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 prevailing market conditions.

When evaluating the total cost of ownership and pricing efficiency of both vehicles, beta replication via ETF 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 the ETF has become a defining competitive advantage relative to futures on a fully-funded basis.