A Cost Comparison of NASDAQ-100 Futures & ETFs

Introduction

This report leverages the framework in The Big Picture Report and compares the all-in cost of replicating Nasdaq-100 Index exposure via futures and ETFs across four common investment scenarios– a fully-funded long position, a leveraged long, a short position and a non-U.S. investor. While these scenarios do not represent all possible applications for either product, they cover the majority of use cases and highlight salient features for each product to assist investors with their implementation decisions. The specific products used in the analysis are the E-mini Nasdaq-100 Index futures (NQ) and the U.S. listed Nasdaq-100 ETF, (QQQ).

Cost Estimates and Assumptions

The framework for the analysis is that of an institutional investor executing a hypothetical order of $100M through a broker. The total cost of obtaining index exposure is divided into two components: transaction costs and holding costs.

Transactions 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 fee charged by the broker for the execution, which varies from client to client. This analysis assumes execution costs of 0.20bps ($2.50 per contract) for NQ futures and 0.62bps ($0.01 per share) for QQQ.1

Market Impact: The second component of transaction cost 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. The analysis in this report requires an estimate of the expected market impact from a hypothetical execution, rather than the actual impact of any specific trade. Based on broker estimates and CME Group’s own analysis, this report assumes 5bps for the NQ futures and 10bps for the ETF.2 The slightly lower market impact for futures makes sense given that NQ futures trade nearly 9x more notional per day than QQQ ETF.3

Table 1 Liquidity Comparison

Product

AuM / OI ($Bn)

ADV ($Mn)

Futures

32.21

32,200

QQQ

50.83

4,400

*ADV and Average AUM / OI for 2017 full-year

Source: CME Group and Bloomberg

Holding Costs

Holding costs are expenses that accrue over the time the position is held. ETF expenses generally grow evenly with time (e.g. ETF management fees, which accrue daily) and future expenses vary over time (e.g. execution fees on quarterly futures rolls).

The sources of holding costs for ETFs and futures are different because of the very different structures of the two products. Some, if not all, of the holding costs detailed below will apply depending on the investor.

ETFs:

  • Investor must finance the full notional value for the ETF (foregoing additional investments), or use margin power within the account at inception Regular T margin requirements of 50% at margin loan rates (maximum 2x leverage)
  • ETF provider charges an annual management fee(20bps per annum for QQQ).
  • Investor is subject to tracking error, or the difference in returns between ETF and underlying index; this represents an additional cost of 9bps per annum for QQQ.5
  • Investors are entitled to receive dividends, but may be subject to withholding tax if domiciled outside the U.S.

Futures:

  • Initial Margin requirement of 3.4% (approximately 29x leverage)6
  • NQ futures must be rolled on a quarterly basis, currently observed as 3-month USD-Libor (3mL) plus 19bps7

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 their 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 3.4% for initial margin, and the remaining cash balance is available for deposit and will generate interest8 to help offset the implied financing rate of the futures position.

This implied financing rate is most readily inferred in the futures calendar spread, also referred to as “the roll”9. 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 an implied financing rate of 3mL +19bps for NQ futures.10

Scenario Analysis

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

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. 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, ranging between 10.4bps for NQ futures and 21.2bps for the ETF. 

The lines slope upward as time passes, reflecting the gradual accrual of the annual holding costs. For the futures, the small jumps illustrate the quarterly roll execution costs. As evident in Figure 1, futures provide 14bps of savings over the 12-month period, and there is no breakeven point in which the ETF becomes more cost effective.

Scenario 2: Leveraged Investor 2x

A major difference between futures and ETFs is the amount of leverage possible with each product. NQ futures require an initial margin deposit of 3.4%, resulting in approximately 29x leverage on the position. The ETF in this analysis – QQQ – is not a leveraged ETF, but may be purchased on margin by those investors who desire to leverage their position. Under Federal Reserve Board Regulation T, there are limits on the amount a broker may lend to an investor wishing to purchase securities on margin. 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.

The 2x leveraged investor is assumed to have $50M with which to take a $100M position. The ETF investor, who must pay the full notional amount of the trade at initiation borrows $50M from a broker to have sufficient funds to follow through on the transaction. The cost of holding an ETF position purchased on margin is therefore equal to that of the fully-funded investor from Scenario 1 plus the interest expense charged on the borrow $50M at 3mL +40bps.11

For a futures position, it is not a question about borrowing money as the investor with $50M already has over 13x the required initial margin. In contrast to the fully funded investor, the 2x leveraged investor’s amount of cash to deposit is reduced by one-half and will only generate enough interest to offset one-half of the 3mL-based financing on the total futures notional. Consequently, the 2x leveraged investor will incur the implied financing of the remaining one-half of the futures notional plus the positive spread of the full $100M contract value. This means the holding cost of the investor can be viewed as the same as the fully-funded scenario plus the added interest expense of $50M at the baseline funding rate of 3mL.

Figure 2 shows that, as a function of leverage, the total cost of futures and ETFs increased relative to the costs in the fully-funded scenario. However, the cost of leverage is higher for ETFs due to above-Libor borrow rates.  Thus, the 2x leveraged investor would save 34bps more via futures than ETFs over a 12-month holding period; and this cost advantage would persist across all time horizons at the 3mL and roll levels observed at the time of analysis.

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:

Futures:

  • Receive implied financing rate12
  • Receive 3-month USD-Libor on $50M cash deposit

ETFs:

  • Receive the management fee (20bps per annum) and benefit from tracking error (9bps per annum)
  • Receive 3mL –40bps on $100M raised from the short sale13
  • Receive 3mL on $50M cash balance

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. 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, regardless if futures are trading rich or cheap. At the 3mL +19bps roll average, futures provide 34bps more savings compared to the average ETF over a 12-month holding period. 

Scenario 4: Non-U.S. Investor

Non-U.S. investors in the U.S. equity market are subject to a withholding tax on dividend payments by U.S. corporations. The typical base withholding rate is 30 percent, resulting in a “net” dividend payment received by foreign investors equal to 70% of the “gross” dividend available to U.S. investors.

This withholding tax also applies to fund distributions paid out by the ETFs. 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. This translates into a total cost that is 32bps higher than that for the fully-funded long ETF investor over a one-year holding period.

Futures contracts do not pay dividends. For non-U.S. investors, futures on qualified indices are not subject to a dividend withholding tax per IRS Rule 871(m). The Nasdaq-100 Index is believed to be a qualified index product, so non-U.S. investors are exempt from withholding tax on NQ futures.

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, with the quarterly jump in the grey line illustrating the impact of the withholding tax for the ETF holder. As a result, futures offer 46bps of savings over a 12-month holding period, and this cost advantage holds true in perpetuity.

Other Considerations

This analysis has focused on cost up to this point. There are plenty of other factors, however, that impact investors’ product selection decisions. For completeness, the more salient considerations are enumerated here.

Tax: E-mini Nasdaq-100 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.14

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 may have such restrictions.) Futures are also not subject to Regulation SHO.

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 similar to 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 ETFs. 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.

Margin offset: CME offers significant cross-margining efficiencies between different products, which provides capital efficiencies for leveraged investors. 

Conclusion

As presented in previous reports around total cost analysis, the cost advantages of futures are compelling, and these advantages extend to E-mini Nasdaq-100 futures. The 2x leveraged investor can save 34bps per annum when using NQ futures in lieu of QQQ ETF over a 12-month holding period. On average, futures also provide savings of 46bps for non-US investors and 34bps for short investors over the same holding period. The most cost-effective vehicle for the long investor depends on the length of holding period, implied financing level, and the ETF management fee. Given the costs observed at the time of this analysis, the long investor would save on average 14bps per annum using futures in lieu of ETFs. 

Table 2 Summary of Results

        Total Futures Cost Savings by Scenario (in bps) *

 

Scenario 1

Scenario 2

Scenario 3

Scenario 4

 

Full-Funded

2x Leveraged

Short Investor

Non-U.S. Investor

Nasdaq-100 Futures

+14bps

+34bps

+34bps

+46bps

Table 3 Most Cost-Effective Choice

Scenario

Roll is Cheap
(Below 3-month USD-Libor)

Roll is Rich
(Above 3-month USD-Libor)

Fully-Funded

FUTURES

FUTURES15

Leveraged(2x)

FUTURES

FUTURES

Short Investor

FUTURES

FUTURES

Non-U.S. Investor

FUTURES

FUTURES

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 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 questions or comments about this report or CME Equity Index products, contact equities@cmegroup.com.


1 Transaction cost estimates are based on “middle-of-the-range” pricing for institutional clients.

2 Average impact based on feedback from liquidity providers.

3 Average daily value traded in 2017 (full-year).

4 The annual management fee is 20bps for QQQ.

5 The tracking error of 9bps per annum for QQQ is referenced from both Bloomberg and ETF.com based on latest 12 months (Jan. 2017 – Dec. 2017)

6 Margin amounts are subject to change. On January 8, 2018 the initial margin estimate for E-mini Nasdaq-100 future was $4,500 on a contract notional of roughly $133,355.

7 This analysis uses a roll cost of 3mL +19bps, which was the respective average cost during the preceding eight quarterly rolls from December 2015 through December 2017.

8 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.

9 Since futures expire on a quarterly basis, an investor wishing to maintain a futures position will realize this cost when “rolling forward” their positions by liquidating the nearby contract and re-establishing the position in the deferred month contract.

10 This analysis uses the 3mL rate of 1.57% during the most recent roll (Dec- Mar 2018) and a roll level of 3mL +19bps, which was the respective average cost during the preceding eight quarterly rolls from March 2016 through December 2017.

11 Typical PB borrow rate of 3mL +40bps for an institutional investor is assumed.

12 The short sale of futures does not require a loan of shares to sell short no nor is there an associated borrow fee. The sale of futures is identical to the purchase, with the same margin posted with the clearing house.

13 The ETF holder borrows shares to sell short from a broker and pays a borrow fee, which is deducted from the interest paid on the cash raised from the sale. A standard broker fee of 40bps per annum is assumed, resulting in a rate return on the cash raised of 3mL – 40bps.

14 This is a general statement. Each specific product needs to be assessed against the relevant applicable criteria in order to determine if the product in question is eligible.

15 Futures implied financing would have to richen to 3mL +31bps for QQQ to be more cost effective over a 12-month holding period.

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