Could someone explain to me the basic financing advantage of futures over ETFs?

B

bjr89

As someone who has never used futures, I have always simply purchased ETFs on margin if I desired to use any leverage. I was told that with futures I would avoid paying the margin interest that is required when you buy stock on margin. But isn't there an implicit cost of interest in the futures contract? That is, in an efficient market, wouldn't this difference between stocks and futures be arbitraged? Therefore it wouldn't matter the type of instrument used and one would be indifferent? I'm sure I'm wrong but don't understand why. Would really appreciate an answer to this newbie question.

Maybe you could illustrate the difference for me with an simple example. Say I wanted to buy $2 worth of S&P 500 exposure for every $1 dollar invested. Could you illustrate the difference for me using SPY (using a portfolio margin account at IB) and using the E-mini S&P 500 mini contract to achieve the same 2:1 exposure? I know that you can get much greater leverage with futures due to the lower margin requirement, but I still don't understand how it is also cheaper.

Thanks in advance.
 
1 es contract = ~100k
initial margin for 1 es contract = around 2.5k

so you're paying 2.5k of your cash to play with 100k on margin

you would need 50k cash to buy 100k worth of SPY on margin usually, so you can see that futures allow you to do more with less
 
recession2016, thanks for your reply.

I understand how futures can allow for greater leverage, but shouldn't the implied cost of interest that is priced into the futures price be about the same as the rate of interest charged on the margin loan if one were to buy an ETF on margin? I have a portfolio margin account and so I can get the leverage I desire just fine... I'm more concerned if there is a difference in price. That is, is the implied rate of interest in a futures contract less than IB's margin interest for an ETF? And if so, how much? What kind of rate is typically priced into a futures contract? Risk-free?
 
bjr89 said:
recession2016, thanks for your reply.

I understand how futures can allow for greater leverage, but shouldn't the implied cost of interest that is priced into the futures price be about the same as the rate of interest charged on the margin loan if one were to buy an ETF on margin? I have a portfolio margin account and so I can get the leverage I desire just fine... I'm more concerned if there is a difference in price. That is, is the implied rate of interest in a futures contract less than IB's margin interest for an ETF? And if so, how much? What kind of rate is typically priced into a futures contract? Risk-free?
More...

You are correct. The future is a forward contract that uses the risk free rate to discount back to the present. It makes no difference how much leverage you are getting. However....the retail interest rate you pay at your broker is NOT going to be the risk free rate, usually way higher. So the forward contract does not know what your personal interest costs it simply uses the risk free rate to satisfy the no arbitrage principle in all forward contracts.
 
bjr89 said:
recession2016, thanks for your reply.

I understand how futures can allow for greater leverage, but shouldn't the implied cost of interest that is priced into the futures price be about the same as the rate of interest charged on the margin loan if one were to buy an ETF on margin? I have a portfolio margin account and so I can get the leverage I desire just fine... I'm more concerned if there is a difference in price. That is, is the implied rate of interest in a futures contract less than IB's margin interest for an ETF? And if so, how much? What kind of rate is typically priced into a futures contract? Risk-free?
More...

there's also the 60/40 rule, 60% of income from futures counts as long term capital gains unlike an ETF unless you hold it for a year without selling
 
If you are trading straight, unhedged directional bets, be very careful and judicious with futures contracts. Have a larger account balance in place per contract than you think you need.

James
Director, Quantitative research
XXX
Boulder, CO
 
Thanks for the additional input, Maverick, recession, and Stockmarketmap. I really appreciate it.

I intend to hold the position for a year and then rebalance. I'm trying to apply a modest amount of leverage (2:1) to a risk balanced portfolio, or risk parity as it's usually called. So it kind of makes my decision between futures and ETFs a little tougher as I have to weigh the cost of the interest differential in favor of futures and the 60/40 vs 100/0 tax differential in favor of ETFs.

In the case of ETFs at IB, they charge the Fed Funds rate of 0.37% + ~1.2%. So I guess now my question is: which risk-free rate gets used in the pricing of a futures contract? For a one year futures contract, is it simply the one year treasury rate?
 
bjr89 said:
Thanks for the additional input, Maverick, recession, and Stockmarketmap. I really appreciate it.

I intend to hold the position for a year and then rebalance. I'm trying to apply a modest amount of leverage (2:1) to a risk balanced portfolio, or risk parity as it's usually called. So it kind of makes my decision between futures and ETFs a little tougher as I have to weigh the cost of the interest differential in favor of futures and the 60/40 vs 100/0 tax differential in favor of ETFs.

In the case of ETFs at IB, they charge the Fed Funds rate of 0.37% + ~1.2%. So I guess now my question is: which risk-free rate gets used in the pricing of a futures contract? For a one year futures contract, is it simply the one year treasury rate?
More...

The one year T-bill is a good approximation. And if you are holding for one year, the tax is the same on the ETF as the future.
 
Oh I didn't know that. I was under the impression that a futures contract is taxed at 60/40 even if held for over a year. Thanks again.
 
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