Among institutional investors, financial futures have long been considered an effective way of representing beta in their own portfolios quickly and in a targeted manner.

Such deployments as funded futures do not constitute leveraging, but instead aim to exclusively establish market exposure in an extremely efficient way.

In today’s investment world, however, it is precisely in this function that exchange-trade funds have been outstripping futures in many equity markets.

This is documented by calculations used in a model developed specially for iShares to quantify the precise performance differential between futures and ETFs. As the S&P 500 chart demonstrates, in recent months futures have been significantly underperforming ETFs. A detailed examination of the causes suggests that this trend is likely to continue.


What are the causes of the underperformance of futures?

There are two main reasons why futures are becoming increasingly ineffective in modeling equity markets efficiently.

The first is a question of supply and demand: during periods of sustained positive sentiment on equity markets, the counterparties for long investments with futures are few and far between.

This has an unfavorable impact on the price. The second development with a lasting effect concerns the binding and more rigid equity ratios that are set to come into force across Europe from January 2015.

In the U.S., the so-called Volcker Rule had a similar effect: banks, which were once the most important counterparties and kept the futures market functioning smoothly, are successively rethinking their business strategies.

Because capital is becoming more expensive for them, they are reducing their exposure ― and the result is increasing distortions on futures markets. 

This consequently means that for institutional investors an approach based upon funded futures is becoming less and less attractive, as the equity market underlying the respective equity futures is being modeled increasingly imprecisely, and costs are rising.

For example, roll costs on the Euro Stoxx 50 rose last year almost 10-fold. By contrast, ETFs have been making advances: The overall cost ratio has fallen sharply, fund volumes have increased significantly and markets have become more liquid. In terms of fungibility as well as in respect of cost-effectiveness, this means equity ETFs have already left comparable futures trailing for many institutional investment portfolios. 


Which investors are currently profiting from ETFs in place of funded futures?

The question of whether an institutional portfolio would benefit today from ETFs in place of funded futures, and to what extent, is dependent upon many individual factors: For example, the asset allocation, the average holding period as well as trading processes and costs all play important roles. The experts at iShares collect data on a continuous basis, and evaluate this for specific scenarios. Upon request, the individual portfolios and processes of institutional investors can also be analyzed.


When do ETFs present an alternative to futures?

With the cost of futures rising, institutional investors need to consider alternative investment instruments. If high intraday liquidity is required, ETFs represent a sound and cost-effective substitute. With over 5,200 available products around the world, ETFs offer greater flexibility in terms of market exposure.

Investors should always assess which investments are the most efficient. In this conjunction, investors should not shy away from questioning established assumptions about their utilization. For example, the cost of individual vehicles can change substantially and structurally over time. This needs to be analyzed carefully before each invest decision is taken.

By Jane Leung, Head of iShares Asia Pacific