This report compares the all-in cost of replicating the S&P 500 total return¹ via equity index futures and ETFs.

Given the diversity of clients and potential uses for both ETFs and futures, there is no “one-size-fits-all” answer to the question of which is more cost-efficient. The optimal choice depends on the details of both the client and the specific trade.

The approach is, therefore, to consider four common investment scenarios – a fully-funded long position, a leveraged long, a short position and a non-U.S. investor – and compare the costs of index replication with futures and ETFs in each. While these scenarios do not represent all possible applications for either product, they cover the majority of use cases, and analysis of the scenarios provides insights into factors that investors should consider when making their implementation decisions.

This analysis compares the CME E-mini S&P 500 future (ticker: ES) with the three US-listed S&P 500 ETFs: SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV) and Vanguard S&P 500 ETF (VOO).

The goal of this report is to quantify the cost of replicating the total return of the S&P 500 index over a given period of time using equity index futures and ETFs. The framework for analysis will be that of a mid-sized institutional investor executing through a broker intermediary (i.e. not direct market access, or DMA) for a hypothetical order of $100 million.

The total cost of index replication is divided into two components: transaction costs and holding costs.

Transaction costs are expenses incurred in the opening and closing of the position. These apply equally to all trades, regardless of the time horizon.

Commission: The first component of transaction cost is the commission, or fee, charged by the broker for the execution. These charges are negotiated between parties and vary from client to client. This analysis assumes execution costs of $2.50 per contract (0.25bps) for E-mini futures and 2.5 cents per share (1.25bps) for ETFs.²

Market Impact: The second component of transaction costs is market impact, which measures the adverse price movement caused by the act of executing the order.

Market impact can be very difficult to quantify. In the simplest case – an unlimited market order sent directly to the exchange – the 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. However, as the execution methodology becomes more sophisticated and extends over a longer period of time (e.g. a working order participating at 25 percent of the volume, or an over-the-day VWAP target) it becomes increasingly difficult to separate the impact that was caused by the trade from market movements unrelated to the trade.

When facilitating investor orders in any one of the products under consideration, liquidity providers will hedge with the least expensive alternative between futures, ETFs and the replicating stock portfolio. This creates a “pool” of S&P 500 liquidity in which each product benefits from the liquidity of the others, which in turn greatly increases the liquidity of all products.

Based on broker estimates and CME Group's own analysis, the market impact of the hypothetical $100 million order is estimated to be 1.25bps for E-mini futures, 2.0bps for the SPY ETF, and 2.5bps for both IVV and VOO.

As a “sanity check” on these values, it is observed that $100 million represents 0.06% of the average daily notional value traded in the ES future of approximately $173 billion (2015 average). As such, a 1.25bps impact estimate – equivalent to one tick increment – appears reasonable.

Given that the liquidity of the ES future is nearly 7x that of the SPY and more than 130x that of the IVV and VOO combined, the impact estimates for these products initially appear quite low. However, if one factors in the liquidity pool effect in the S&P 500 and the frictional costs of converting between the various products, the incremental cost of 0.75bps for SPY and 1.25bps for IVV and VOO – corresponding to approximately 1.5cps and 2.5cps, respectively – appear reasonable.

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, which 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.

ETFs: The holding cost of an ETF is the management fee charged by the fund for the service of replicating the index return (generally through the purchase and maintenance of the underlying stock portfolio). The management fee for the three ETFs in our analysis ranges between 5.0 and 9.45bps per annum.

A second potential source of holding cost is tracking error between the fund’s returns and those of the index (other than those due to the application of the management fee). This risk will be ignored in the analysis that follows, as it has never been an issue with the ETFs under consideration and as such, there is very limited basis for estimating the magnitude or impact of potential deviations.

Futures: Futures contracts are derivatives and provide leverage. Unlike an ETF, where the full notional amount is paid by the buyer to the seller at trade initiation, with futures contracts, no money changes hands between the parties. Rather, both buyer and seller deposit margin of approximately 5.2 percent³ of the notional of the trade with the clearing house to guarantee their obligations under the contract.

As compared with the ETF management fee, buyers of futures contracts are implicitly paying the sellers not only to replicate the index returns, but also to do so with their own money. As a result, the price of a futures contract contains a component that represents the interest charges on these “borrowed” funds⁴.

Given the trading price of the futures, one can infer the rate that the market is implicitly charging on these “borrowed” funds. While this funding cost is implied in all futures transactions, it is most readily inferred from trading in the futures roll and frequently referred to as the “roll cost.”

Comparing this implied interest rate with the corresponding ICE LIBOR rate over the same period, one can calculate the spread to ICE LIBOR, and determine whether the future is rolling “rich” (implied funding above ICE LIBOR, positive spread) or “cheap” (implied financing below ICE LIBOR, negative spread).

For a fully-funded investor (i.e. one that has cash equal to the full notional value of the position), the richness or cheapness of the roll is not merely a “theoretical” cost but the actual holding cost for index replication via futures. The investor realizes this cost by buying the futures contracts and holding his unused cash in an interest-bearing deposit. Through the futures contracts, he pays the implied financing rate on the full notional of the trade, while on the unused cash on deposit he receives a rate of interest, which is assumed to be equal to 3-month USD-ICE LIBOR (3mL)⁵. The difference between the interest paid and interest earned is the holding cost of the position and is equal to the richness or cheapness of the roll.

Unlike a management fee, the implied financing cost of the quarterly futures roll is not constant but determined by the forces of supply and demand and arbitrage opportunities in the market.

Historically, the implied spread to ICE LIBOR of ES futures was below the lowest management fees on any ETF. Over the ten-year period between 2002 and 2012, the ES futures roll averaged 2 bps below fair value⁶.

Since 2012, the pricing of the roll has become more volatile and traded at varied levels as shown in Figure 1, with the richness averaging 35bps in 2013, 26 bps in 2014 and 8bps in 2015.

This recent richness is attributable to two main factors: changes in the mix between natural sellers and liquidity providers on the supply-side of the market, and changes to the costs incurred by liquidity providers (particularly banks) in facilitating this service.

In a balanced market, natural buyers and sellers trade at a price close to fair value – neither party being in a position to extract a premium from the other. When no natural seller is available, a liquidity provider steps in to provide supply (i.e. sell futures) at a price. The greater the demand on liquidity providers, the higher (and more variable) the implied funding costs will be. Conversely, if market conditions attract more natural sellers, this demand on liquidity providers can be diminished via the redistribution amongst market participants, which will both stabilize and lower the implied funding costs.

The persistently strong S&P 500 returns from 2012 to 2014 (average annual growth of 20.2 percent) caused a decrease in the size of the natural short base, as institutional investors reduced shorts and biased their positions toward long exposure. This increased demand on the remaining short-side liquidity providers – e.g. leveraged shorts, hedge funds and U.S. banks – occurred at a time when access to balance sheet and funding were increasing, all of which placed upward pressure on the implied financing of futures, as displayed in Figure 1.

In the analysis that follows, E-mini S&P 500 futures are evaluated against the corresponding ETFs in two scenarios where the futures are assumed to roll at the 2014-2015 two-year average of 20bps above 3mL, and at the H2-2015 sub-ICE LIBOR average of 5.7bps below 3-month USD-ICE LIBOR.

Table 2 summarizes the cost estimates used in the analysis. The execution fees of the quarterly futures roll are assumed to be the same as in the transaction cost, applied twice at each roll.

Having established baseline transaction and holding cost estimates, it is now possible to compute the total cost of index replication via futures and ETFs for various use cases. This report will consider four scenarios: a fully-funded investor, a leveraged investor, a short seller and an international investor (i.e. non-U.S. domicile). In each case, total cost is computed for all holding periods up to 12 months.

All scenarios assume the same transaction costs and recognize the round-trip fees and market impact at trade initiation. Futures roll costs are assessed on the Wednesday before each quarterly expiry.

The starting point for each graph (the intersection with the vertical axis) represents the round-trip execution cost, ranging from 2.9bps for futures to between 6.5 and 7.5 bps for ETFs. Most of 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 quarterly futures rolls. Because the annual management fees on the ETFs are below an implied richness of +20bps on futures, the graphs of the ETFs slope upward more slowly than that of the futures. The opposite holds true when futures carry an implied cheapness and the downward slope of the line represents the premium that can be extracted via rolling futures cheap to ICE LIBOR. At an implied cheapness of -5.7bps, the ETF management fees are above the holding cost of the future, and this divergent relationship exists for the entire period.

For short holding periods, the higher transaction costs of the ETFs make the futures more economically attractive regardless of the roll richness or cheapness (futures line below all three ETF lines). This makes futures a particularly attractive tool for more active, tactical and short-term traders. For longer-term holders, the cumulative effects of implied financing make the ETF a more efficient alternative when futures are rolling rich, and less efficient when futures are rolling cheap.

Equity index futures are leveraged instruments. The investor posts approximately 5 percent margin to the exchange, which results in over 20x leverage on their position. The three ETFs in this analysis are not leveraged⁹ but may be purchased on margin by investors who desire leverage.

The difference is the quantity of leverage that is possible. Under Federal Reserve Board Regulations T and U, there are limits on the amount a broker may lend to an investor wishing to purchase securities on margin.

Under Reg T, the maximum amount that can be lent is 50 percent of the purchase price, resulting in a maximum of 2x leverage. More sophisticated investors may be eligible for portfolio margining through a prime broker under which they could potentially achieve 6-8x leverage under Reg U. Greater than 8x leverage is not possible.

To derive a holding cost for the ETF position purchased with leverage, standard prime broker lending rates for an institutional client of 3mL + 40bps are assumed.

Two-times Leveraged Investor

The starting point for the analysis is the 2x leveraged case. This implies that the investor has $50 million with which to take on $100 million of exposure.

The ETF investor, who must pay the full notional amount of the trade at initiation, borrows $50 million from a prime broker to fund the purchase. The holding cost of the leveraged position is therefore the same as the fully-funded position (Scenario 1) plus the interest carry on the borrowed $50 million at 3mL + 40bps.

The dashed lines in Figure 4 show the total cost of index replication on a 2x levered basis for holding periods up to 12 months.

Eight-times Leveraged Investor

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 increased intrinsic cost of leverage embedded in the futures. In the 8x levered case, the 40bps funding differential on 87.5 percent 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 3mL rates of approximately 0.25 percent. 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.

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 3mL – 40bps¹¹.

In addition to the cash raised from the short sale, the investor must post an additional 50 percent of the notional of the trade in cash to the broker as margin¹². The additional funds posted to the prime broker will be assumed to earn 3mL.

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, 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 3mL + 20bps on the $100 million
2. Receive 3mL on $50 million cash

ETFs

1. Receive the management fee of 5 - 9.45bps
2. Receive 3mL - 40bps on $100 million raised from the short sale
3. Receive 3mL on the $50 million deposited with the prime broker

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

In general, foreign 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 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 2.15 percent, which implies an additional 64.5bps 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 index¹³. There is no futures equivalent to the dividend withholding tax on ETF shares.

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

Certain international investors are able to reclaim some or all of the dividend or 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 U.S. investor (Scenario 1).

For dividend rates less than 95 percent of gross (i.e. 5 percent withholding) those futures outlined herein are more cost effective across all time horizons given the futures rich scenario of 3mL +20bps. Given the one-sided nature of dividend withholding tax in this analysis, it is fair to discern that there is a variable relationship between the degree of richness embedded in futures and the ETFs’ required break-even withholding rate. If futures richened beyond 3mL +20bps a foreign investor could be withheld greater than 5 percent on ETF dividend payments and still breakeven – albeit, even at moderate levels of richness of the futures roll, it still requires a very high reclaim rate to abate the withholding impact exacted on ETFs.

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.

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 percent long term and 40 percent 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 U.S.-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 that pays a management fee to another asset manager or have concerns about investors’ perceptions of their use of other issuers’ funds in the portfolio.

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

¹ Price return plus dividends.

² These rates are indicative of typical “middle-of-the-range” pricing for institutional clients. While commissions and fees are a focus for short-term traders, in the context of the longer-term analysis here, they make only a very small contribution to the total cost.

³ At time of writing the margin requirement on E-mini S&P futures is $4,700 on a contract notional of roughly $91,300. Margin amounts are subject to change.

⁴ The argument is symmetric for the seller. The short sale of an ETF would generate cash which would earn a rate of interest. The sale of a futures contract generates no cash and so the implied interest in the futures price compensates the seller for this.

⁵ As with other assumptions in the analysis, this value represents a “middle-of-the-range” yield on uninvested cash.

⁶ Goldman Sachs, “Futures-Plus”, 22 January, 2015.

⁷ The blue line shows the weighted average richness of the roll over the three weeks leading up to expiry, and the grey bars indicate the highest and lowest average daily rate over the period.

⁸ Source: CME Group Equity Quarterly Roll Analyzer tool

⁹ Leveraged ETFs are excluded from this analysis, as these have path-dependent returns which are very different from standard ETFs or futures.

¹⁰ To simplify the graphical representations, Figures 4-6 show the average of the total costs of the SPY, IVV and VOO. The individual results for each ETF are within ±2bps of the value shown at all time horizons.

¹¹ This rate, combined with the assumption on long funding of 3mL + 40bps, results in an 80 bps “through-the-middle” prime broker bid / offer, which is consistent with market standards.

¹² Higher leverage may be eligible under portfolio margining but we will focus on the 2x levered case.

¹³ The market price of a futures contract is a function of interest rates and anticipated future dividends. Deviations from fair value can be attributed to either component based on the investor’s assumptions. For example, the futures roll trading above fair value can be viewed as the result of above-market implied funding rates, a lower dividend assumption or a dividend withholding tax. The market standard is to attribute deviations to implied funding costs unless there is a known ambiguity around the timing or quantity of a particular dividend.