This report leverages the framework in The Big Picture: A Cost Comparison of Futures and ETFs and compares the all-in cost of replicating S&P Select Sector exposure via futures and ETFs across four common investment scenarios. While the analysis uses E-mini Financial Select Sector futures (XAF) and the Financial Select Sector SPDR ETF (XLF), the cost comparison framework presented can also be applied to the other nine S&P 500 select sector future and ETF pairings.
COST ESTIMATES AND ASSUMPTIONS
The framework for the analysis is that of an institutional investor executing a hypothetical order of $25,000,000 through a broker. The total cost of obtaining index exposure is divided into two components: transaction costs and holding costs.
Transaction costs are expenses incurred in the opening and closing of the position. These costs apply equally to all trades, regardless of the time horizon.
Commission: The first component of transaction cost is the execution fee charged by the broker, which varies from client to client. This analysis assumes execution and clearing costs of $2.50 per contract (0.3bps) for XAF and $0.01 per share (4bps) for XLF.1
Market Impact: The second component of transaction costs is market impact2, which measures the adverse price movement caused by the act of executing the order. Market impact can be difficult to quantify and depends on the liquidity of the instruments and the way in which an order is executed. However, for this analysis, it is acknowledged that sector ETFs historically have had greater on-screen liquidity than sector futures. Based on broker estimates, the analysis assumes 7bps of market impact for XAF and 5bps for XLF.3
Holding costs are expenses that accrue over the time the position is held. These generally grow linearly with time (e.g. ETF management fees, which accrue daily), although there are some that are discrete but recurring (e.g. execution fees on quarterly futures rolls).
The sources of holding costs for ETFs and futures are different, owing to the very different structures of the two products. Some, if not all, of the holding costs detailed below will apply depending on the investor.
- Investors must fully pay for the ETF (forgoing additional investments), finance the full notional value, or use margin power within the account at inception
- Regulation T margin requirement of 50% at margin loan rates (maximum 2x leverage)
- Daily management fee charged by the ETF provider
- 14 bps per annum for each Sector SPDR ETF
- Investor is entitled to receive dividends and could be subject to additional withholding tax if domiciled outside the U.S.
- Initial margin requirement of 4.56%4 (approximately 22x leverage)
- E-mini Financial Select Sector futures must be rolled on a quarterly basis, currently observed as Libor +2bps5
Unlike ETFs, futures do not carry management fees, but rather an implied financing cost embedded in the price. Since the buyer of futures is implicitly paying the seller to replicate the index returns with his or her own capital, the futures price will be adjusted to reflect the cost of these “borrowed” funds. Recall, the buyer of futures incurs only a nominal cash outlay of 4.56% for initial margin, and the remaining cash balance is available for deposit and will generate interest6 to help offset the implied financing rate of the futures position.
This implied financing rate is most readily inferred in the futures roll cost.7 The price differential between the nearby and deferred contract implies a financing rate, which is compared to the corresponding USD-Libor rate over the same period to determine whether the future is rolling “rich” (implied rate “paid” via holding the future is above Libor) or “cheap” (implied rate below Libor). This analysis assumes a “rich” roll cost of 3-month USD-Libor (3mL) +2bps for XAF.
In each case, the total cost is computed for a holding period of 12 months. All scenarios assume the same transaction costs and market impact at both trade initiation and exit.
Scenario 1: Fully-Funded Long Investor
For a fully-funded investor, the total cost is the sum of transaction costs plus the pro-rata portion of annual holding costs.
The starting point for each graph represents the round-trip execution costs: 14.7bps for XAF, and 18.0bps for XLF.
The lines slope upward as time passes, reflecting the gradual accrual of the annual holding costs, with small jumps in the futures line due to the cost of executing the quarterly futures roll.
As is evident in Figure 1, there is no breakeven point at which the ETF becomes more cost-effective than the futures over the 12-month holding period. In fact, the futures remain the more cost-effective vehicle in perpetuity as the quarterly roll execution costs (0.3bps per leg) plus implied financing (3mL +2bps) incurred on the future, XAF, are less than the annual management fee (14bps) remunerated on the XLF ETF.
Scenario 2: Leveraged Investor
A major difference between futures and ETFs is the amount of leverage possible with each product. E-mini Financial Select Sector futures require an initial margin deposit of 4.56%, resulting in 22x leverage on the position. For ETFs, the investor is required to deposit a minimum margin of 50% of the purchase price at trade initiation, resulting in a maximum of 2x leverage on the position.8
The 2x leveraged investor is assumed to have $12.5M with which to take a $25M position. The ETF investor, who must pay the full notional amount of the trade at initiation, borrows $12.5M from a prime broker to fund the purchase. The holding cost for a 2x levered ETF position is therefore the same as the fully-funded investor from Scenario 1 plus the interest expense charged on the borrowed $12.5M at 3mL +40bps.9
For a futures position, it is not a question about borrowing money, as the investor with $12.5M already has 11x the required initial margin. Rather, it is a case of generating less interest to defray the baseline financing cost (3mL) embedded in the future. In contrast to the fully-funded investor, the 2x leveraged investor’s amount of cash to deposit is reduced by half and will only generate enough interest to offset one-half of the 3mL-based financing on the total futures notional. As a result, the 2x leveraged investor will incur the implied financing on the remaining half of the futures notional plus the expense of the positive (or less the credit of the negative) spread on the full $25M contract value. Hence, his or her holding cost can be viewed as the same as the fully-funded scenario plus the added interest expense of $12.5M at the baseline funding rate of 3-month USD-Libor.
Figure 2 shows that as a function of leverage, the total cost associated with futures will never exceed that of the ETFs. For the 2x leveraged investor, the ETF holding cost has increased by 29.7bps per annum more than the futures due to above-Libor rates charged on borrowed funds by a prime broker. Consequently, futures are more economical across all time horizons at the 3mL and roll levels observed at the time of the analysis.10
Scenario 3: Short Investor
A short position provides negative market exposure and is inherently leveraged. When analyzing the economics of a short position, it is important to remember that the holding costs for the long investor become benefits for the short. The holding costs for short positions in futures and ETFs can be summarized below:
- Receive implied financing rate11
- Receive 3mL on $12.5M cash deposit
- Receive the management fee of 14bps per annum
- Receive 3mL -40bps on $25M raised from the short sale.12
Figure 3 shows that the holding costs are negative for both the futures and ETFs – over time, the investor’s relative performance versus the short return of the benchmark improves, as depicted by the downward slope of the lines.
However, due to the higher funding spreads charged by prime brokers, XAF futures provides greater cost savings than XLF ETFs across all holding periods.
Scenario 4: Non-U.S. Investor
In general, non-U.S. investors in the U.S. equity market are subject to a withholding tax on dividend payments by U.S. corporations. The base withholding rate is 30 percent, resulting in a “net” dividend received by foreign investors equal to 70 percent of the “gross” dividend available to U.S. investors.
This withholding tax also applies to fund distributions paid out by ETFs. All of the ETFs in this analysis pay a quarterly distribution, which represents the pass through of dividend income received by the fund on the underlying shares held. The dividend yield of the Financial Select Sector Index is approximately 1.78 percent, which implies an additional 32bps holding cost per annum for non-U.S. ETF investors due to the withholding tax. Futures contracts, unlike ETFs, do not pay dividends. Consequently, there is no futures equivalent to the dividend withholding tax on ETF shares 13.
Figure 4 shows the holding comparison for a fully-funded long position (Scenario 1) as experienced by a non-U.S. investor based on a 30 percent withholding. The jump in the purple line illustrates the impact of the withholding tax for the XLF ETF holder. As a result, the XAF future is the more cost effective product in perpetuity.
The choice between Sector futures and ETFs is not an either-or decision and is scenario- and sector-dependent. There are however, significant potential cost advantages of E-mini S&P Select Sector futures over the corresponding ETFs. Given the assumptions made in this white paper, the fully-funded investor may save, on average, 24bps when choosing to use Select Sector futures in lieu of ETFs, and may enjoy savings in excess of 40bps on the Energy and Industrial sectors for a 12-month holding period. For the 2x leveraged and short investors, Select Sector futures may provide on average 44bps and 9bps of savings, respectively, with some Select Sector futures potentially providing more than 60bps of cost advantage. For the non-U.S. investor, the cost advantages of futures may be even larger at an average of 74bps. Figure 5 summarizes the savings for all 10 sectors across the four scenarios.
Figure 5: Total Potential Cost Savings by Select Sector Future (in bps)*
|Scenario 1||Scenario 2||Scenario 3||Scenario 4|
|Full-Funded||2x Leveraged||Short Investor||Non-U.S. Investor|
|Consumer Discretionary (XAY)||+16bps||+37bps||+19bps||+65bps|
|Consumer Staples (XAP)||+33bps||+53bps||+0bps||+116bps|
|Health Care (XAV)||+24bps||+44bps||+10bps||+75bps|
|Real Estate (XAR)||+34bps||+54bps||-6bps||+34bps**|
*Please note that negative figures reflect a higher expense than the ETF.
**Note: This analysis assumes a non-U.S. investor incurs a dividend withholding tax of 30% for Real Estate and Utilities sector futures per IRS 871(m).
Figure 6 shows the cheapest alternative for fully-funded investors based on holding period and implied financing of the futures.
Figure 6: Scenario: Fully-Funded, Roll Cost at a Premium to 3-month USD Libor
|Futures are more cost-effective than ETFs for all investors when the Roll Cost trades at, or below, the following holding periods:|
|30 days||60 days||90 days||180 days||1 year||2 years||3 years|
|Consumer Discretionary (XAY)||+52bps||+31bps||+22bps||+15bps||+11bps||+10bps||+9bps|
|Consumer Staples (XAP)||+48bps||+30bps||+20bps||+13bps||+10bps||+9bps||+8bps|
|Health Care (XAV)||+50bps||+30bps||+21bps||+14bps||+11bps||+9bps||+8bps|
|Real Estate (XAR)||+43bps||+27bps||+16bps||+10bps||+8bps||+6bps||+6bps|
Investors are reminded that the results in this analysis are based on the stated assumptions and generally accepted pricing methodologies. The actual costs incurred by an investor will depend on the specific circumstances of both the investor and the particular trade, including the trade size, time horizon, broker fees, execution methodology and general market conditions at the time of the trade, among others. Investors should always perform their own analysis.
- Transaction cost estimates are based on “middle-of-the-range” pricing for institutional clients.
- In the simplest case – an unlimited market order sent directly to the exchange – the market 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.
- Average provided by survey of liquidity providers, assuming the order is executed in line with volume at a reasonably low percent, so as to minimize impact (15-20%).
Liquidity can be sourced from the sector future, the sector ETF or from the index’s underlying cash components. These sources are fungible for most liquidity providers and thus the market impact of trading sector futures or sector ETFs could be considered equal with negligible differences.
- Margin amounts are subject to change. On January 9, 2017, the initial margin requirement for XAF was $3,300 on a contract notional of roughly $72,500. Please consult cmegroup.com for the most current margin information.
- The analysis uses the average roll cost for 2016 (full-year).
- It is assumed interest earned on cash deposits will be on par with the baseline risk-free rate used to value futures. This analysis uses a financing rate equal to 3mL to align with standard convention for U.S.-based equity products.
- Because futures expire on a quarterly basis, an investor wishing to maintain a futures position will realize this cost when “rolling forward” his or her positions by liquidating the nearby contract and re-establishing the position in the deferred month contract.
- Unlike futures, ETFs are subject to Federal Reserve Board Regulation T margin requirements.
- Standard prime broker lending rates for an institutional investor of 3mL +40bps are assumed.
- This analysis uses average 3mL rate of 0.80% and a roll level of 3mL +2bps, which were the respective averages during the preceding four quarterly rolls.
- The short sale of futures does not require a loan of shares to sell short or pay the associated fee. The sale of futures is identical to the purchase, with the same margin posted with the clearing house.
- The ETF holder borrows shares to sell short from a prime broker and pays a borrow fee, which is deducted from the interest paid on the cash raised from the sale. A typical prime broker fee of 40bps per annum is assumed, resulting in a rate return on the cash raised of 3mL – 40bps.
- For non-U.S. investors, Real Estate and Utilities Select Sector futures may be subject to IRS 871(m), resulting in a different dividend withholding tax requirement (WHT). This analysis assumes Real Estate and Utilities futures will be subject to WHT. It is assumed the remaining eight sector futures will not be impacted by this requirement as they are deemed qualified indexes. Clients should contact their futures commission merchant (FCM) for more information on how withholding works.
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