July 29, 2014 / 7:14 PM / 4 years ago

Institutions shift to exchange-traded funds as futures grow costly

NEW YORK (Reuters) - Institutional investors, like endowments and sovereign wealth funds, are trading some of their stock futures contracts for exchange-traded funds, an action they say saves them money and effort while providing comparable returns.

Traders work on the floor of the New York Stock Exchange shortly after the market's opening in New York July 28, 2014. REUTERS/Lucas Jackson

It is a shift prompted by the regulation-driven rising cost of futures trading, and it has ETF issuers such as BlackRock Inc (BLK.N) salivating. In the past six months, the largest U.S. ETF provider said it had some $2 billion in trades into ETFs from investors that previously bought futures and swaps with that money.

The shift underscores a broader trend on Wall Street, where investors are seeking alternative ways to access markets as banks cut back on trading operations in the face of higher capital requirements and other regulations. That in turn has driven up the cost of derivatives such as futures contracts and is making some securities, including individual bonds, harder to find.

In pre-crisis 2008, a typical stock futures contract held for a year would cost around $100 annually for $100,000 of contract value. Now, it would cost between $300 and $500, as bank dealers mark up these contracts to cover the costs of the higher capital requirements.

At the same time, ETF price wars among major providers are driving down management fees and resulting in very cheap access to funds tracking broad stock indexes.

“Unless the cost of capital changes, then ETFs will take more and more share of the futures and swaps market,” says Daniel Gamba, who oversees BlackRock’s iShares institutional business in the Americas.

To be sure, most of the money in the futures market will stay there because it is invested by those that want the kind of leverage they cannot get from ETFs, says Chintan Kotecha, a New York-based analyst at Bank of America Merrill Lynch.

But with the entire $2.6 trillion ETF market but a small fraction of the $48 trillion invested globally in futures and swaps, even an incremental move away from futures leaves plenty of room for increased ETF sales, says Gamba.


A long-term investor seeking to invest $100 million in the S&P 500 to gain equity market exposure would save about $250,000 in fees in a year by doing it via ETFs instead of futures but would have similar investment results, based on a recent analysis by Bank of America Merrill Lynch.

Here’s how that would work: A long-term futures investor might pay $5 million, or 5 percent margin, for a $100 million futures contract on the Standard & Poor’s 500 stock index and put the remaining $95 million into a money market mutual fund or other cash equivalent. Every few months, as the contract expired, the investor would have to roll it over into a new contract.

At the end of the year, the total costs would be $417,000 for that $100 million contract. If the underlying index had moved up 5 percent during that time, the investor would net $4.58 million. If it had moved down 5 percent, the investor would have lost $5.42 million.

If, instead, the same $100 million were put directly into an S&P 500 stock index ETF, the costs would be $164,000. A 5 percent increase in the underlying index would then net the investor $4.84 million. A 5 percent drop would cause a loss of $5.16 million.

Both scenarios have their nuances. With futures, there could be errors in forecasting dividends, and with ETFs, there could be errors in tracking that could add or subtract costs.”

That calculus has driven Makena Capital, a Menlo Park, California manager of $20 billion for endowments, foundations and sovereign wealth funds, to chose ETFs in some cases because of their lower cost and ease of use.

“If you are holding a futures contract for only two weeks, no big deal, but if you are holding it for a year and have to do this roll four times, that’s four transaction costs, versus holding an ETF, where there is no need to roll,” Michel Del Buono, the firm’s global investment strategist said in an interview.

Other investors are making the same move, BlackRock says. A sovereign wealth fund recently traded $400 million directly out of an S&P futures contract into the iShares Core S&P 500 ETF (IVV.P), BlackRock’s global iShares chief, Mark Wiedman, told investors at the company’s annual meeting last month. BlackRock declined to name the investor.

It is that long-term crowd, such as Makena, that ETF providers are eager to attract, since their assets tend to be “stickier” because of their buy-and-hold nature.

Contract sellers may not have to worry about losing significant market share to “ETFs putting their straw in the futures milkshake,” because many investors still want the leverage only futures contracts offer, according to Ben Johnson, an analyst with Chicago-based research firm Morningstar.

But with trillions of dollars in long-term money in the futures market, Gamba is feeling pretty good. “We don’t know how much we can capture through ETFs, but even a slight capture of that could be very substantial,” he said.

Reporting by Ashley Lau in New York; Editing by Linda Stern and Steve Orlofsky

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