Welcome to intended consequences.
As a result of increased regulation and capital requirements for financial institutions, the total cost of beta exposure might be leveling out across various instruments.
Historically, institutional investors have viewed futures and swaps as the most convenient (and cheapest) way to access broad-based equity benchmarks, such as the S&P 500 and Russell 2000, as well as developed and emerging market indexes. Yet the growing popularity and declining cost for certain exchange-traded products has allowed ETPs to challenge other instruments in ease of use and total cost of ownership.
Financing costs for swaps in particular have exploded, said Reginald M. Browne, senior managing director at Cantor Fitzgerald in New York. A metric that we find a lot of pensions and endowments don't consider is the hedging cost of their own counterparty. If a pension wants $1 billion in exposure to the Russell 2000, what will be the net impact of that trade? Have they considered both explicit and implicit costs?
Exchange-traded funds and other strategies that involve direct (or indirect) investment in the underlying securities typically do not have a long-term counterparty on the other side of a transaction looking to lay off or get paid for the market risk.
For these long-biased investors that fully fund their beta exposure, Mr. Browne said securities lending revenue makes a difference. A long and lend investor in the iShares Russell 2000 ETF can make up the difference in cost against a swap by lending ETF shares.
The other side of the transaction, however, is not as cost effective, said Rick Nelson, chief investment officer of Commonfund in Wilton, Conn. Going short with an ETF, the investor pays the borrowing cost.
For example, Mr. Nelson said that shorting emerging markets equity exposure through futures, alongside a long S&P 500 futures position, allowed Commonfund to maintain emerging markets equity manager alpha, while avoiding emerging markets equity risk. This portable alpha trade also saved the transaction cost of selling the emerging market equities, he said.
Still, we expect the cost of swaps to go up, he added.
The direct impact to the swaps market in particular can be seen in the notional amounts outstanding supported by reporting dealers as compared to other institutions, according to the Bank for International Settlements. On $2.4 trillion in outstanding notional value of equity-linked swaps as of June 30, dealers were counterparty to 27% of the exposure compared to 29% two years earlier. Non-dealer financial institutions increased their market share to 64% from 56%.
In a recent client note, Anand Omprakash, equity derivatives strategist for BNP Paribas in New York, wrote that uncertainty surrounding future banking regulations has the potential to reignite volatility in future futures rolls.
He continued: To avoid potentially elevated futures costs (and cost volatility), our analysis finds that investors not seeking levered exposure may consider ETFs as a suitable alternative to maintain a long position in the underlying S&P 500 index.
For international index exposure, according to an analysis by Cantor's Mr. Browne, the decision on ETFs vs. swaps is not as clear cut and comes down to investor preference.
Added Commonfund's Mr. Nelson: Some asset owners are more comfortable with physical exposure, but we look at both total cost of ownership as well as trading flexibility.
Factors that must be considered when making cost comparisons include the underlying expense ratio of the exchange-traded fund, commissions and spreads, and securities lending revenue, both embedded within the ETF and of the ETF itself, as well as the roll richness of the future and the collateral requirements of a swap.
The market is suffering from a lack of institutions willing to sell futures while the demand for buying futures remains, said Hilary Corman, managing director at BlackRock Inc. in New York. Now, as clients look to ETFs, she said, they are asking more questions about ETF mechanics and liquidity as well as operational issues around the technology required to monitor holding a new financial instrument.
One area where Mr. Nelson believes ETFs can build an advantage is international exposures that include a currency hedge. According to research firm XTF Inc., currency-hedged debt and equity ETFs have added $6.2 billion in assets this year across 30 funds with $21.8 billion in assets under management.
Particularly notable inflows have gone to products that hedge out exposure to the yen and euro. Examples include the WisdomTree Japan Hedged Equity Fund, which has drawn $1.3 billion in net flows in the past month through Nov. 14, and Deutsche Bank's db-X MSCI EAFE Currency Hedged Equity Fund with $189 million in the same time period, according to XTF data. n