What are Derivatives?
Derivatives are financial instruments that derive their value based on underlying assets such as commodities, currencies, interest rates, and stock prices. Derivatives are considered the umbrella of many sub-financial instruments under which futures, forwards, and options. ETFs are generally not classified under derivatives; however, there are derivative-based ETFs; such as the ProShares Ultra S&P 500 ETF.
What are futures and ETFs?
Dating back to ancient Greece and Mesopotamia, future contracts are standardized derivative contracts that are traded on stock exchanges and are settled daily (Market to market-MTM); they almost mimic the performance of underlying assets, including stocks, bonds, commodities, currencies, market indices, and interest rates in which investors bet on the direction of the future price of the underlying assets. They have uniform terms, agreed-upon payment dates, and fixed maturity dates that usually are never reached, and delivery rarely happens. Investors usually roll the contract i.e., selling a long position expiring at the front month (the nearest due date) and buying the equivalent contract expiring at a further-out month with the new speculated market price to maintain a derivative position rather than having a cash delivery avoiding costs and obligations of the physical or cash settlement. Roll yield refers to the gain or losses from rolling the contracts. The future contract expires either in March, June, September, or December. According to CME Group (2022), a total of 878.335 M futures contracts were traded globally in 2022 Y.T.D, accounting for a 29.4% increase compared to 2021[ CME Group (April 2022). CME Exchange Volume Report- Monthly].
On the other hand, Exchange-Traded Fund (ETF), which was first introduced in 1993, is a basket of open-funded pooled securities traded on stock exchanges managed by brokerage firms; it is backed by the actual assets, including commodities, indices, and other assets, or even specific investment strategies.
CME Group (April 2022). CME Exchange Volume Report- Monthly
Moreover, most ETFs are index funds in which they hold the same securities in the same proportions as a specific stock or bond market index.
The table gives a comparison between the size of both markets.
Differences between trading ETFs and the corresponding Future Contract
There are several differences between both; futures do not have annual management fees, unlike ETFs, they are traded all day long, while ETFs are traded during the normal trading hours. In addition, the future margin is capital-efficient with initial margins of 5%-10% of the speculative amount in which the trader pays a certain ratio of the contract's price and not all of it upfront, while the initial margin of ETFs is 50%. For liquidity, future contracts are more liquid than ETFs; for example, the E-mini S&P 500 trades daily on average more than the total existing ETFs globally. Also, the ETF's Trust can be liquidated had the trust's balance or the net asset value (NAV) falls under a specific level or by agreement of shareholders owning at least 66.6% of all outstanding shares regardless of the strength of the underlying asset. Furthermore, futures have more favorable tax treatments than ETFs as per section 1256 of the Internal Revenue Code (IRC), which entails the 60/40 rule; 60% of the gain is treated as more favorable long-term capital gains and 40% as ordinary income, while the ETF investor pays taxes at an ordinary income rate that might take as much as 39%. Another difference is that futures contracts do not pay dividends, while some ETFs do.
Comparing a future contract and an ETF tracking the same index, for instance, the Russell 2000 ETF (IWM) and the RTY Futures Contract, we find that the notional value of 1 RTY Contract is worth the index price times a multiplier, while the ETF would only be the index's price.
Moreover, 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, according to CME.
Are futures cheaper than ETFs?
Futures are more cost-effective than ETFs since they have fewer transaction costs, holding costs, and margins than ETFs. For example, suppose an investor decided to invest a USD 1000 in the stock exchange and assuming that one ounce of gold is trading at USD 1000. In that case, the investor can buy one ounce of gold using the SPDR Gold Shares (GLD), while with the same amount, she/he could buy a contract that is almost worth 10 ounces of gold because of the margin in which every one dollar in futures can represent 20 times or more of the physical commodity. However, it is worth mentioning that the higher return yields higher risk.
Can ETFs hold futures?
Yes, they can. There are different types of ETFs, one of which is the futures ETFs. This type of ETF tracks a futures index. They provide investors with the benefits of futures without the hassle of rolling over. However, there are risks to trading futures ETFs; inaccuracy is one risk in which changes in prices and interest rates can cause inaccurate tracking of the underlying asset yielding unexpected loss or gain i.e., tracking error. There are two types of tracking error; contango, which refers to the spot price being less than the futures price, and backwardation which refers to the spot price being higher than the futures price, causing an upward bias.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients