Over the last 25 years, E-mini Stock Index futures and Exchange Traded Fund (ETFs), have been among the most successful products traded throughout the world.   And given the diversity of clients and the many potential uses for both futures and ETFs, there is no one-size-fits-all answer to the question of which is the more cost-effective instrument. It will depend upon factors such as commissions, implementation cost, as well as the holding period or the trading strategy employed while focusing only on the total cost analysis, which sets aside other attributes such as liquidity, near 24-hour access and capital efficiencies that make futures the better alternative.

Factoid:  The primary stock index futures contracts (S&P500, S&P midcap 400, Russell 2000, Nasdaq 100 and Dow Futures) substantially out-trade their ETF counterparts in average daily dollar volume.  Source: CME Group, Bloomberg

We'll show you some of the advantages of trading stock index futures over ETFs, using the Russell 2000, where one can trade the E-mini Russell 2000 futures (RTY) or the ETF counterpart iShares Russell 2000 ETF (IWM).

Futures contracts are usually much larger than ETF shares. The notional value of E-mini Russell 2000 futures is roughly $69,000 (obtained by multiplying index value by $50) while one iShare Russell 2000 ETF  share is worth only $137. 

It would require 500 shares of IWM to equal one futures contract. Hence transaction costs may be less when buying one futures contracts as opposed to 500 shares of the IWM ETF.

Trading the E-mini Russell 2000 Index futures requires an upfront performance bond margin of $2,850 (4%) to take a position in one contract*. To purchase the same dollar amount of the IWM ETF, you would have to put up $34,000, or half the amount of the purchase, according to Reg-T margins as required by the Federal Reserve bank of New York.

*subject to change 

While ETFs do, in some cases, offer after-hours trading, they are not generally available to most investors on a 24-hour basis. Futures, on the other hand, trade nearly 24-hours-a-day with excellent liquidity despite the underlying cash equity market being closed.

While ETFs can be held in perpetuity, E-mini Russell 2000 futures contracts have distinct quarterly expiration cycles four times a year: March, June, September and December. If you wanted to maintain your futures position, you would have to roll the E-mini Russell 2000 futures throughout the year, incurring some additional costs. This additional cost is minimal,and lower than incurring the 20-basis point management fee on the IWM ETF.

It is not what you make that matters, it is what you take home.

Consider two investors: an E-mini Russell 2000 futures investor and an investor in the Russell 2000 ETF, IWM. Both make $10,000 trading profits in a trade that was held less than one year. The Russell ETF investor, with a short-term gain would pay taxes at an ordinary income rate while the Russell 2000 futures trader would be taxed as a section 1256 contract and pay a blended 60/40 long-term/short-term rate. 

In the top tax bracket, ordinary income could take as much as 39% of the ETF trader’s profits. Futures are treated with 60/40 rules, where 60% of the gain is treated as the more favorable long-term capital gains and 40% is ordinary income. The blended rate is somewhere around 28-30%.  The savings can be thousands of dollars on a futures trader’s tax bill. 

Russell 2000 ETFs do usually pay dividends to the shareholder while E-mini Russell 2000 futures do not. However, futures prices are discounted to reflect the lack of dividend payment.

E-mini Russell 2000 futures vs. iShares Russell 2000 ETF(IWM)

*Year ending Sept 2008