By Susan Chan, Head of iShares Asia Pacific
Futures are particularly popular among sophisticated investors such as asset managers and pension funds that need to invest efficiently and cheaply in liquid, easy-to-access markets. This long-held acceptance of futures has created a huge industry with exceptional liquidity.
However, the evolution of financial markets has produced new methods of gaining beta exposure efficiently, and many institutional investors are now adopting them. The efficiency of ETFs, in particular, is surpassing that of futures in many cases due to current market conditions, forcing institutional investors to reconsider their choice of financial instruments. By the end of 2014, assets under management of S&P 500 ETFs surpassed open interest of the respective futures contract for the first time.
Different tools, different costs
Listed equity index futures are among the most widely used derivatives contracts available in the financial markets. As of end December 2014, there was more than $ 353bn in open interest on S&P 500 futures only.1
Futures can be used by institutional investors to implement several types of strategies, such as sophisticated trading strategies, leveraged strategies and simple beta plays. For this comparison we will focus on using futures and ETFs for the simple implementation of a beta play.
ETFs and futures are similar in many respects. They are both delta-one instruments which aim to replicate an index, net of fees, and their prices are therefore linked to the index. Both vehicles have become extremely popular due to their intra-day liquidity, exchange-traded nature, relative safety, transparency and other unique benefits they deliver to investors.
However, the mechanisms of ETFs and futures are very different, resulting in varying levels of efficiency as market conditions change.
One key difference is that futures contracts expire on a monthly or quarterly basis, while ETFs are open-ended vehicles with no maturity constraints. Investors wishing to maintain their futures exposure beyond a contract’s expiry incur the cost of rolling the futures contract.
There are also other cost differences. ETFs’ holding costs are driven by rebalancing costs and replication methodology while occasionally being partially offset by securities lending revenues. ETFs’ trading costs can be summarised as clearing, execution commissions and primary market creation or redemption costs.
Futures’ trading costs include relatively low execution and clearing commissions. However the major driver of the price of futures, aside from the underlying index level, is the “basis”, which is the difference in price between the future and the index. This is very dependent on offer/demand imbalances, as well as the cost of carry (including funding). The impact of the basis materialises when rolling a futures contract to the next expiry, within the investor’s holding period. The cost for funding a short futures position and the natural imbalances between offer and demand mean that futures typically trade rich, and therefore that the roll is done at a cost for a long investor.
The rising cost of futures
One of the challenges facing equity index futures today is a specific supply and demand dynamic. While pension funds, endowments or asset managers may go long or short financial futures, demand for long exposure far outpaces that for short exposure.
Futures investments require two parties, and therefore a short must exist for every long. Investment banks are the main suppliers of short futures, which they synthetically manufacture.
The bank must hedge those short positions, which forces them to deploy their balance sheet. As a consequence of changing regulations, such as the Basel framework in Europe, bank capital is becoming more expensive, driving up hedging costs.
This has resulted in the market suffering from a lack of institutions willing to sell futures, while demand for buying futures remains strong. Over the last 12 to 15 months futures contracts have become more expensive than their long-term historical average, particularly around year-end, (i.e. for the December rolls), when banks are more unlikely to enter into or maintain long carry positions.
Futures contracts exhibit what is referred to as ‘cheapness’ or ‘richness’ in a similar dynamic to that of premia versus discounts in the ETF space. Currently, futures contracts are “rich”, creating a performance drag and making them less efficient in delivering cheap access to benchmark indices.
This performance drag is well-documented2 and illustrated by the recent trend for futures contracts to roll rich. For example the roll cost on TOPIX had an average roll cost of 0.11% from 1998 to 2014 and has been rolling on average for the past 12 months 57bps rich. This trend is also seen in the S&P 500 futures contract versus corresponding ETFs, which are currently cheaper. See the chart below on the comparison of the tracking difference between an S&P 500 ETF and a corresponding futures contract.
This trend is also seen in futures tracking a wide range of other global indexes3. In Asia, aside from TOPIX equity index futures, the trend is seen on the NSE Nifty, the Hang Seng, the Nikkei 225 and the MSCI Singapore, among others. In Europe, a group of major index futures, including the EURO STOXX 50, the FTSE 100 and the DAX-30 are rolling richer than the longer term average. While in the US, the Russell 1000 and the S&P MidCap are other examples of the tendency.
As the cost of futures rises institutional investors need to consider alternative investment instruments. By contrast, the overall cost ratio for ETFs has fallen sharply, there is a wider spread of liquidity throughout ETFs and fund volumes have increased significantly. As a result, ETFs may be the better choice for some institutional investment portfolios.
Growth of ETFs
ETFs have become more efficient tools for beta implementation as the market has grown. Global AUM ETF AUM grew 16% to $2.78trn in 20144, and BlackRock projects that the industry will add another $1 trillion in assets by 2017, resulting in even better liquidity and lower trading costs.
The cost of ETFs offering broad exposures is being reduced by competition and the increasing size of funds, which allows managers to spread fixed costs such as administration and custody fees among more units.
While ETFs were initially created to provide access to liquid equity indices representing the large capitalisation segment of well-established developed markets, the industry has expanded, with more than 5,7005 products available globally today.
A continuing trend
The past decade has seen an unprecedented level of growth in index investing.
We believe that this trend will continue, putting increased focus on instruments that offer efficient exposure to indices.
As financial markets grow and evolve the outcome of vehicle comparisons change. We urge investors to continuously monitor their full opportunity set beyond myths and pre-assumptions and select the solutions that are best for them at that specific time of trading.
For example, five years ago ETFs were at a much earlier stage of development, with less choice and liquidity than today, often resulting in higher trading and management costs compared to futures. As described above, that situation has changed dramatically to where ETFs are now more efficient than futures in many cases. The efficiency and breadth of offering of ETFs is likely to continue to grow.
A key factor to watch in the current trend of richness of futures will be cost of the balance sheet, which evolves as the banking business model adapts to market and economic conditions. While each bank will deploy capital differently, and have different financing costs, it appears rather unlikely that any of them will achieve the lower levels of cost of capital enjoyed before the 2007/2008 financial crisis.
Banking regulation will also evolve as the Basel framework and the Volcker Rule reach their full-implementation status. While it is difficult to speculate on their impact, we deem it unlikely that regulators will unwind these frameworks or materially change the direction undertaken.
As for any financial instrument, beta vehicles evolve over time as markets and regulation change. The last 12 months have witnessed a significant change in market conditions, which should prompt investors to reconsider their long-held ideas and practices related to accessing beta.
Futures are experiencing headwinds driven by supply and demand dynamics and the increased cost of capital caused by regulatory changes. A persistent richness of the futures roll versus its fair value has been observed across several contracts over the last 12 to 15 months – particularly towards year-end. Large scale, liquid exposures that very commonly use futures such as the S&P 500 and the TOPIX have both recently seen hugely increased costs.
ETFs, meanwhile, have benefitted from tailwinds associated with increased volumes and larger AUM, producing continually lower costs over the past five years.
While ETFs and futures will continue to co-exist and serve investors well across different portfolio usages and applications, BlackRock expects ETFs to be the winner as they increasingly represent an efficient substitution opportunity for beta investors.
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By Susan Chan, Head of iShares Asia Pacific