Futures contracts have historically been the main tool for institutional investors to gain short- and long-term exposure to an equity index. However, almost out of nowhere, the growth of equity-index ETFs amongst traders and investors has been extraordinary. In a short number of years, ETFs are now considered a key investment tool used by institutional investors, not only in the equity markets but now in fixed income.
According to a study published by Greenwich Associates in February, of 183 US-based institutional investors surveyed, 65% of institutional ETF users employ the funds in their fixed income portfolio.
“They increase liquidity for corporate bonds, making them easier to trade,” said one asset manager in the study.
The growth and maturation of ETFs amongst the buy-side has been well documented, however the reality is that investors are now evaluating ETFs alongside their derivatives portfolio to determine the best tool for hedging and gaining market exposure.
The same study found that 58% of investors have replaced their derivatives products, such as equity futures contracts, with ETFs in the last year, and 78% of futures users plan to replace their existing futures position with an ETF in the next 12 months.
For example, Blackrock’s iShares, the world’s largest ETF issuer, saw net inflows into its European funds of approximately $35 billion, which included $4 billion of switches from fully funded futures positions into the iShare EMEA range.
It also found that three quarters of US institutions would opt for an S&P 500 ETF over S&P 500 futures as a means of obtaining the most cost-effective beta exposure for a fully funded S&P 500 position.
The predominant factor here is cost. Long fully funded investors that use equity index futures are seeing rising costs of holding and rolling their positions. This is particularly exacerbated at the time of quarterly expirations.
In addition, faced with increased regulatory burdens and higher capital requirements, some financial institutions are turning to ETFs to escape the cost pressures associated with derivatives. Most recently, Fidelity became the latest fund manager to launch a range of ETF products in order to capitalise on this trend.
In the study, Andrew McCollum, managing director for Greenwich Associates and author of the report said: “Greenwich Associates believes the market is only beginning to see the impact of this trend, which will provide a source of strong growth for ETFs.”
On the other hand, it goes without saying that equity index futures are still used throughout the world on an incredible scale. According to data from CME Group, the E-Mini S&P500 futures traded 429.8 million contracts during 2015. Overall in its equity index futures range, it saw 564.9 million contracts changing hands.
According to CME’s own report on ETFs and futures published this month, the E-Mini S&P 500 future is traded seven times more in dollar value per day than the three S&P 500 ETFs combined. It also traded two and a half times more per day than the entire US ETF market put together.
Furthermore, futures are still widely considered the most effective tool for managing short-term risk. “For the vast majority of our clients, we have found that futures may provide them the greatest flexibility to fulfil short-term risk management and performance enhancement goals such as cash equitisation and securitization, portfolio rebalancing, currency hedging and transition management,” said one survey respondent in a report issued by the CME Group last year.
So what will be the determining factor in the showdown between ETFs and futures? Which product will reign supreme? To find out, The Trade Derivatives pits two leading experts against each other to debate the issue. Defending futures is Tim McCourt, global head of equity products at CME Group, and for ETFs Patrick Mattar, head of iShares EMEA broker-dealer sales at Blackrock.
1) On rolling costs
McCourt: “At CME Group we have posed the question through the cheapness or richness of the roll. What we mean by that is the imbedded spread to Libor that is in the S&P 500 future. In the second half of 2015, roll cost has dramatically cheapened to an average of three month Libor minus six basis points. So with that cheapening to a scenario where the roll is sub-Libor, futures are the most cost effective tool for the investors to access the S&P 500 regardless of holding periods.”
Mattar: "Over time, the cost of rolling a future from a commission point of view builds up. Comparing management fees, an index mutual fund was perceived as the default beta vehicle. But the cost dynamics have shifted dramatically in the past three years and ETFs are becoming popular with both short and long term investors.”
2) On Basel III costs
McCourt:"If the market place is feeling increased pressure on capital, that would universally affect all capital used to facilitate US equity index transactions. If investors were moving from futures to ETFs, the ETF creation process that would need to be facilitated by the US banks will be treated with the same increase capital charge.”
Mattar: “Bank treasury departments are trying to manage the cost of capital. Regulation has been a key driver of the increase in costs traders now face, and has meant that end futures buyers has seen an increase in costs of anywhere from 0-60 basis points annualised, depending on contract. ”
3) On financing
McCourt: “What investors need to focus on is the relationship between the embedded financing level of the future and the management fee for ETFs. It is not necessarily the low management fee of an ETF that makes them a more attractive vehicle for the long-term buyer. It is really the relationship between what ETFs charge in management fees, which currently range between 5 and 10 bps for the S&P500 US-listed ETFs, the embedded richness or cheapness of the future, and the holding period. It is really important for investor to understand what the break-even point is based on their timeline.”
Mattar: "If you have more natural buyers than natural sellers a liquidity provider needs to fill the gap. Over time equities attract natural buyers and bullish market phases intensify this. More constrained bank balance sheets have been unable to keep up, and so for the fully funded investor simple economics have made ETFs an attractive alternative.”