The analysis for the 8x leveraged case proceeds in a similar fashion. In this case, the investor has $12.5 million of cash with which to obtain $100 million of exposure. The ETF investor therefore has an $87.5 million loan from the prime broker while the futures investor has an $87.5 million reduction in their deposit.

The solid lines in Figure 4 show the cost comparison for the 8x levered case. As the amount of funds borrowed increases, the incremental borrowing cost of a prime- broker funded ETF position increases, as compared with the intrinsic leverage of futures. In the 8x levered case, the 40bps funding differential on 87.5% of the notional of the trade results in a 35bps greater increase in the holding cost of ETFs relative to futures.

This analysis has been conducted using current 3m Libor rates of approximately 0.25%. As interest rates rise, the absolute cost of leveraged exposure will increase for both products. However, the difference between the holding costs of ETFs and futures is not a function of the absolute rate but of the spread between cash on deposit and borrowed cash and persists across different interest rate regimes.

 Scenario 3: Short investor

 A short position provides negative market exposure and is inherently leveraged.

 With ETFs, the leverage comes in the form of a loan of

 shares to sell short by a prime broker. The sale of the

 borrowed shares raises cash, which remains on deposit with the prime broker. The short seller pays a bps per annum fee to the lender of the ETF which is deducted from the interest paid on the cash raised by the sale. 

A typical prime broker borrow fee of 40bps per annum  is assumed, resulting in a return on cash raised of  3m Libor – 40bps .

In addition to the cash raised from the short sale, the investor must post an additional 50% of the notional of the trade in cash to the broker as margin. The additional funds posted to the prime broker will be assumed to earn 3m Libor. 

Because they are using derivatives, the short seller of futures does not need to borrow shares or pay the associated fee. The sale of a futures contract is identical to the purchase, with the same margin posted with the clearing house. 

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. ETF management fees cause a systematic underperformance relative to the benchmark which, for the short investor, represents an excess return. The richness of the futures roll provides a similar benefit for futures investors. 

The holding costs for short positions in futures and ETFs can be decomposed as follows:

Futures:

1)   Receive futures’ implied funding rate of 3m Libor + 20bps on the $100 million

2)  Receive 3m Libor on $50 million cash 

ETFs:

1)Receive the management fee of 5 - 9.45bps

2)Receive 3m Libor – 40bps on $100 million raised from the short sale

3)   Receive 3m Libor on the $50 million deposited with the prime broker.

 Figure 5 shows that in both cases the holding costs are negative – over time, the investor’s relative performance versus the short return of the benchmark improves, as demonstrated by the downward slope of the line.

However, due to the combination of higher ETF transaction costs and the funding spreads charged by prime brokers, the futures provide a more cost-effective implementation across all time horizons.

Scenario 4: International 

CME does not provide tax advice. Investors should consult their own advisors before making any investment decision.

In general, foreign investors in the US equity market are subject to a withholding tax on dividend payments by US corporations. The base withholding rate is 30%, resulting in a “net” dividend received by foreign investors equal to 70% of the “gross” dividend available to US investors.

This withholding tax also applies to fund distributions paid out by ETFs. All three 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 S&P 500 is approximately 2.0%, which implies a 60bps additional holding cost per annum for foreign ETF investors due to the withholding tax.

Futures contracts, unlike ETFs, do not pay dividends. The market price of the future contains an implied dividend amount which generally corresponds to the full gross dividend yield on the underlying index. There is no futures equivalent to the dividend withholding tax on shares.

Figure 6 shows holding cost comparison for a fully-funded long position (Scenario 1) as experienced by a non-US investor based on a 30% withholding.

In the 3-month period prior to the first dividend ex-date the comparison is identical to Scenario 1: the lower transaction costs of futures make them a cheaper alternative. Just prior to the cross-over point where ETFs become more cost effective, the 15bps impact of the withholding tax on the first quarterly dividend hits the total cost of the ETF causing the jump in the red line. As a result, the future is a more cost effective alternative over all time horizons.

Certain international investors are able to reclaim some or all of the dividend / distribution withholding tax on ETF distributions. A partial reclaim reduces the size of the “steps” in Figure 6 while a tax-exempt foreign investor (i.e. a full reclaim) is economically equivalent to a US investor (Scenario 1). 

For dividend rates less than 92% of gross (i.e. 8% withholding), futures are more cost effective across all time horizons. 

Unlike ETF management fees, which are beneficial to short investors, the withholding cost on fund distributions does not result in outperformance for foreign investors looking to take on short exposure. The standard in the stock loan market is that the borrower of the security pays the full gross dividend.

Other considerations

This analysis has, thus far, focused on cost. There are, however, a number of other factors that impact investors’ product selection decisions. For completeness, the more salient considerations are enumerated here. 

Tax: E-mini S&P 500 futures are section 1256 contracts with a blended U.S. capital gains treatment of 60% long term and 40% short term, regardless of holding period, which may improve the after-tax efficiency of futures versus other alternatives. 

UCITS: Equity index futures are eligible investments for European UCITS funds, while US-listed ETFs are not. Currency: The leverage inherent in a futures contract allows non-USD investor greater flexibility in the management of their currency exposures as compared to fully-funded products like ETFs.

 Short Sale: Many funds have limitations, either by mandate or regulation, which limit the ability to sell short securities. These funds may, however, be able to take on short exposure via derivatives such as futures. (UCITS funds have such restrictions.) Futures are also not subject to locate requirements, Regulation SHO or Rule 201.

Fixed Versus Variable Dividends: A futures contract locks in a fixed dividend amount at the time of trade, while  ETFs accrue the actual dividends to the fund’s NAV as and when they occur.

Product Structure: ETFs are mutual funds while futures are derivatives. Fund investment mandates and local regulations may treat these structures differently and impose differing degrees of flexibility in their usage by the fund manager. The asset management company (or the particular fund manager) may also have preferences. Some funds may look to limit their use of derivatives and therefore prefer the ETF. Alternately, managers may prefer not to use a product which pays a management fee to another asset manager or have concerns about investors’ perceptions of their use of other issuers’ funds in the portfolio. 

CONCLUSION

Figure 7 summarizes the results of the analysis. For all scenarios but one, futures provide a more cost-effective vehicle for replicating S&P 500 index returns.

The exception is that of a fully-funded US investor (or tax-exempt foreign investor) with a long time-horizon, where the recent richness of the ES roll has increased the cost of futures relative to ETFs. With S&P 500 implied and realized volatility higher in 2015 than at almost any point in the last two years, it remains to be seen how long this situation can persist.

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 other. Investors should always perform their own analysis. For more information on CME Group’s suite of equity index futures and options on futures, please contact your CME Group account manager or sales representative. For questions or comments about this report or CME Equity Index products, contact equities@cmegroup.com.