The Optimal Implementation: ETFs, Futures and Swaps
A buy-side trader considers a series of alternative asset classes when managing a portfolio manager’s order flow. He may trade a slice of the portfolio using program trading analytics and basket technology, or he may trade a single security in the form of an ETF that closely tracks the performance of the underlying portfolio. He may enter into an over-the-counter swap transaction with a dealer, based upon the precise securities held in the portfolio, or he may buy or sell a broad-market stock index futures contract to substitute for the basket trade.
Choosing the right asset class for a particular trade has become extremely difficult. Bid/ask spreads, depth of market, the impact of volatility on valuation and financing rates, the cost of margining and mark-to-the market cash flows, the high costs and settlement risks of international transactions, issues of concentration in counterparty risk – the components of the decision are many and the comparison is complex. In this report, we take an in-depth look at three asset classes commonly used as a substitute for equity exposure: ETFs, index futures and OTC equity swaps, detailing the pros and cons of each and then applying that analysis to a variety of scenarios.
ETFs have grown rapidly over the past several years, in assets and volume and variety. They have the advantage of being exchange-traded, SEC-registered securities that trade in relative transparency on lit exchanges, and they clear and settle on trade-date-plus-three. They comprise everything from broad market indices used as benchmark standards, as well as widely recognized industry sectors and beyond. The most popular ETFs have developed significant secondary market liquidity and are increasingly used by institutions and hedge funds alike as core execution vehicles.
Stock index futures contracts have been around for 25 years, and there is deep liquidity in the broad-market contracts. Spreads are narrow, commissions are cheap, and arbitrage players keep mispricing to a minimum around fair value. Stock index futures, as with baskets and ETFs, trade electronically and are attractive trading tools to traditional traders and black-box, high-frequency strategies alike. Valuation is both simple and transparent, and there is plenty of analytical and execution technology support for trading portfolios of securities and futures side by side.
Lastly, buy-side traders have increasingly adopted over-the-counter equity solutions such as total return swaps, both on the long and the short side of returns. One-quarter of US asset managers and one-third of US hedge funds held OTC swaps at year-end 2008. Swaps are highly customizable, both in terms of the underlying asset or assets and in the duration of the transaction. They can be reset periodically, as desired, and there are no stocks to settle, no fails to chase down.
However, there is no one analytic, no single piece of software that can take into consideration all of the advantages and disadvantages of each of these decisions, but a trader absolutely must have a foundation of knowledge with which to approach the decision. Basis points count, counterparty risk counts, volatility and liquidity and the ability to raise cash on demand certainly counts. The decision today is more important than ever.
The TABB Group Vision Note The Optimal Implementation: ETFs, Futures and Swaps
This TABB Group Vision Note discusses the challenge of choosing the most efficient, most cost-effective trading vehicle and trading strategy for the implementation of a portfolio manager’s investment decision. We look at the tremendous growth in the number and types of ETFs globally, as well as the dramatic increase in daily volume and assets under management for the most active ETF securities. We take a look at the hidden liquidity available in the unique creation / redemption structure underlying exchange-traded funds, and how to appropriately compare liquidity in a basket of securities to the secondary market liquidity in the equivalent ETF. We evaluate liquidity in the listed stock index futures markets and the continuing growth in the popular mini contracts used by both institutions and high-frequency traders alike. And we look at the advantages and disadvantages of the OTC equity swap market, from customization and duration to pricing and counterparty risk. The note is based on conversations and data obtained through interviews with buy-side traders at both hedge funds and traditional asset managers, as well as sell-side swaps desks, ETF desks, program trading desks and ETF algorithm providers.
- Fixed Income