The world of exchange-traded funds has grown exponentially since the first product, State Street’s Spider, was launched in 1993. Today, there are over 800 products in the US and more than 2,600 worldwide, conveying exposure to a plethora of underlying investment themes, from equity indices to commodity futures and currencies.
The first ETFs, like the Spider, typically enabled investors to trade an entire index or portfolio of stocks in a single action – making turning over one’s portfolio as easy as selling one stock. But over the last few years, many variations to the basic ETF and many strategies for trading them have sprung up, many of which involve futures and options.
Most notably, in the US, ETF options have taken off and continue to gain momentum. About 330 ETF options are now traded in the US, according to the Options Clearing Corp, so that they cover almost half of the ETFs available. In 2008, these instruments accounted for 30.3% of all options traded in the US, up from just 3.6% in 2000.
This year, to the end of October, ETFs made up 29.3% of all options traded, proving that their popularity in 2008 was no one hit wonder. Indeed, ETF options are the fastest growing section of the US options business, according to Gary Gastineau, the founder of ETF Consultants, based in Summit, New Jersey. “This is a trend I expect to see continue,” he says.
There is a top tier of very actively traded US ETF options: equity-based products that are broadly held and easy to hedge using options on the underlying index.
In 2008, the top ETF contract was the SPDR S&P 500 ETF Option, which accounted for 8.97% of all options trading in the US. This was followed by the PowerShares QQQ ETF Option, with a market share of 6.19%, and the iShares Russell 2000 ETF Option, with 4.24%.
“It is a huge value-add to have options available for the ETFs,” says Ed McRedmond (pictured), senior vice-president at Invesco PowerShares Capital Management, which offers the QQQ ETF. “To have a more active options market is beneficial for the underlying ETF when it comes to attracting additional assets and generating tighter spreads.”
Small and nimble
The acceptance of ETF options in the US market is due in large part to the success of ETFs themselves, according to Marty Kearney, an instructor at the Chicago Board Options Exchange’s Options Institute. “Investors know a lot about ETFs, and the options strategies you can do with individual stocks certainly transfer over to ETFs,” he says.
Furthermore, unlike equity index options, which are often subject to exclusive licensing agreements limiting them to a single exchange, ETF options can be cross-listed and traded on any of the seven US options exchanges.
The main reasons, however, why many investors use ETF options instead of options on the underlying index are the size of the contracts and how they are settled.
ETF options are usually only one 10th the size of comparable index options and futures. For example, while the SPX, the index option on the Spider, consists of 1,000 shares, the SPY, the comparable ETF option on the same index, only consists of 100 shares. This difference in size means investors can expect the SPY to trade at narrower strike price intervals.
“If you have 300 shares of the Spider and you want to do a covered write, you wouldn’t use the SPX because it is the size of 1,000 shares. The SPY would be an easier way to go,” says Kearney.
Toys for hedge funds
Despite their smaller size, ETF options are not purely the domain of retail investors. Many hedge funds and institutional investors are increasingly using ETF options due to their liquidity, low transaction costs, and the way they are settled.
An ETF option is physically settled into an ETF, whereas an index option is cash-settled. “Investors in options, by and large, would prefer physical settlement rather than cash settlement, in part because there is less risk of having an unfavourable pricing issue,” says Gastineau at ETF Consultants.
Professional investors using ETF options usually do so to hedge positions in their portfolios or take on leverage in a particular sector, says Bradley Kay, an ETF analyst at Morningstar in Chicago.
Commodity ETFs: funds built of futures
The popularity of derivatives on ETFs, especially ETF options in the US, has grown substantially in recent years. However, there are also ETFs on derivatives.
Another area of growth has been commodity-based ETFs, many of which use futures contracts as the basis of their product.
The first commodity ETF, the SPDR Gold Trust, was launched by State Street in 2004. It quickly found an audience and today remains the largest commodity ETF in the world. To gain its exposure, the trust buys actual bars of gold.
However, while buying the physical commodity is well suited to gold, due to its high worth to weight ratio, this is not the case for all commodities. Owning physical commodities such as oil and gas is considered prohibitively expensive. So when further ETFs investing in commodities were launched in 2006, commodity futures were used as the basis of their exposure.
Launched within a few weeks of each other were the Deutsche Bank Liquid Commodity Index ETF, which uses commodity futures to track an index of major commodities, and the United States Oil ETF, which uses futures to invest in the front month oil contract. Today, both are $2bn funds.
“It gave people an easy way to buy or sell an equity through their stock account that represented a pool of commodities. So you did not have to open a futures account,” says John Hyland, chief investment officer of United States Commodity Funds, the Alameda, California-based company that manages US Oil.
Since then, ETFs that invest in commodity futures have taken hold, with an estimated $30bn invested in them.
The amount of trading in the commodity futures market attributable to ETFs’ activity varies from commodity to commodity, and depending on a variety of market factors.
According to Hyland, at the end of November 2009, at least 5% of front month oil futures were owned by commodity ETFs. This number is well down from 20% earlier in the year, when the price of oil was lower and more funds were taking a position in oil.
At that time, about a fifth of all US front month oil futures trading emanated from two or three oil ETFs, such as the USO, and those trading the Goldman Sachs Commodities Index.
“Now that the price is back around $80 a barrel, more than half of our shareholders have moved on,” says Hyland.
Regulator raises big stick
However, this activity has not come without a cost. Worried that excessive speculation might be pushing up energy prices, the Commodity Futures Trading Commission has kept the markets anxiously awaiting a decision about whether it will impose position limits on energy futures traders.
If position limits are imposed, and exemptions are not granted, many ETFs using commodity futures will have their ability to operate severely affected. This is because as investors buy shares in commodity futures ETFs, the managers of the funds must issue “creation baskets” and authorise them for sale to authorised purchasers such as brokerage firms. Because only a finite number of units exist, once an ETF reaches its limit, the manager must get approval to increase the number of “creation baskets”.
Already, the PowerShares DB Crude Oil Double Long ETN, the largest and most liquid exchange-traded product conveying leveraged exposure to oil, was liquidated in September.
Some other ETFs are awaiting decisions from the SEC on whether it will grant their requests to increase their authorised units.
In the mean time, some ETFs, like the United States Natural Gas ETF, which has a market capitalisation of more than $3.5bn and had an average daily volume of 30m shares, has been left with no option but to stop issuing creation baskets.
The prospect of position limits has led some ETF providers, like John Hyland’s US Commodity Funds, to rethink how to provide exposure to the underlying.
Because of the uncertainty, over the last six months Hyland has sold half of UNG’s futures contracts and replaced them with over-the-counter swaps. “We made this change precisely because we are concerned about artificial position limits being brought in without exemptions. If this were to happen, we would have to sell a lot of futures in a small period of time, which is something we would like to avoid,” says Hyland.
Of course, position limits might be imposed that also covered swaps, since they are a different means to the same end.
“If a trader wants to hedge out financials, but does not want to sell it off due to the tax implications, they can put an option on the Financial Select Sector SPDR,” he explains.
This was an especially popular trade in the last 12 months, says Kay. Investors went long on preferred shares in the financial sector, which were paying a hefty yield as the price of financial stocks went down, and shorted the Financial Select Sector SPDR to hedge out their exposure to the sector, while also avoiding the tax implications of making short term capital gains. Kay confirms that Morningstar used this trade in its own model portfolios.
Dig down for value
Although their star is on the rise, trading in ETF options is still heavily concentrated in the top group of 10 or so equity-based products. Nevertheless, there is a diverse list of ETF options tracking commodities, currencies, debt and volatility.
According to Kay, it is the second tier of ETF options – ranked from 10 to 100 in volume – where investors typically find the most interesting price discovery.
“The top tier of ETFs with the deep options markets can tend to be less interesting or useful to hedge funds,” he says. “This is because there is an even more phenomenally deep market on the underlying index. But in second tier ETF options, there is still a reasonable level of liquidity, but no immediately deeper market via an exchange-listed index option, where investors can find interesting arbitrage opportunities.”
The story of ETF options in Europe, however, has not been as happy.
The options on the CAC 40 Master Unit and the Dow Jones Euro Stoxx 50 Master Unit, both listed on Euronext Paris in January 2003, were delisted due to inactivity in May 2005.
Three years later the same fate met Euronext Amsterdam’s ISX Option, on the iShares DJ Euro Stoxx 50 ETF, and Liffe’s IFT Option, on the iShares FTSE 100 ETF. Both had been listed for only three months.
Eurex offers three ETF options, none of them much traded – the iShares Dax (DE) Option, iShares DJ Euro Stoxx 50 Option, and the XMTCH on SMI Option.
“The European ETF and ETF options market has certainly not matched the market in the US,” says James Barr, a spokesperson for NYSE Euronext in London.
One reason is the ample liquidity of the index options on which ETFs are based. So while the success of index options in the US has not come at the expense of ETF options, this does not seem to be the case in Europe.
A surprise on the downside
While the reception of ETF options has been different on the two sides of the Atlantic, the evolution of ETF futures has been more similar, in that the product has struggled to catch on in both markets.
In Europe, there are three ETF futures at Eurex, covering the same three funds as its options.
In the US, the ETF futures market is divided into products traded on conventional futures exchanges, known as ETF futures, and OneChicago’s single stock futures on ETFs.
The two products perform the same function but owe their different names to a regulatory quirk. Futures on ordinary shares were banned from US exchanges until 2002, because the Securities and Exchange Commission and Commodity Futures Trading Commission could not agree on which of them should regulate the product.
Eventually they agreed on dual regulation, and the OneChicago exchange was set up to offer single stock futures.
As ETFs are not strictly speaking shares, but are almost identical to shares in the way they trade, futures on them are offered both by OneChicago, as single stock futures, and by CME Group, as ordinary futures.
The CME has three ETF futures, based on the Spider, the QQQ and the iShares Russell 2000. OneChicago, meanwhile, lists 156 single stock futures on ETFs with a 100 multiplier and 10 with a 1,000 multiplier.
None of these products, in the US or Europe, can be considered a success, as they generate minimal trading.
The reasons for the lack of liquidity in ETF futures, in both Europe and the US, are the long list of already liquid futures on the indices themselves, and their unfavourable tax consequences for end users.
“We see far more interplay in using an index future and an ETF,” says Scot Warren, managing director of equity products and services at CME Group in Chicago. “The products are so similar in terms of their ability to describe the underlying exposure, which creates very interesting and profitable arbitrage opportunities for prop trading funds.”
Ralf Huesmann, head of product strategy at Eurex in Frankfurt, agrees. “There is a very high correlation between the ETF market and the futures market, because whenever someone does a trade on the ETF side, they take a futures trade against it as a very deep hedge,” he says.
Furthermore, end investors consider ETFs and futures a good compromise in lieu of index swaps and their inherent counterparty risk.
||The top 10 US ETF options
|(% of overall options volume in 2008)
|| SPDR S&P 500
|| Powershares QQQ
|| iShares Russell 2000
|| Financial Select Sector SPDR
|| Diamonds ETF
|| Energy Select Sector SPDR
|| iShares MSCI Emerging Markets
|| United States Oil Fund
|| Oil Service HOLDRs
|| iShares MSCI Brazil Index Fund
||Source: The Options Clearing Corporation
At the time CME launched ETF futures in June 2005, says Warren, there was an expectation that there would be more appetite for the product than for index futures, due to the impending launch of single stock futures. The lack of success of single stock futures, however, put that expectation to bed.
Single stocks the future?
Ironically, today, much of the interest in single stock futures is in relation to SSFs on ETFs. While their adoption so far has not been impressive, there is some hope that this might be about to change.
The idea behind the product on the long side is that by creating a delta position using the SSF, an investor should be able to reduce the cost of financing the position. The interest rate component built into the ETF SSF product ought to be less than the rate charged by a brokerage house to finance the outright purchase of the ETF.
On the short side, investors who are short the underlying are subject to recalls of the loan and variation in the interest rate they are charged. By selling the SSF instead, they lock in an interest rate out till term, and are insulated from any recall risk until expiration.
However, there has been a hiccup. One of the problems with SSFs on ETFs is the lack of certainty about the dividend payment.
“There is little guidance for traders on the dividend rates until right before they are about to be paid, and of course it is very difficult to make a rational market in a forward contract if you do not know what the dividend is going to be. And participants do not like to trade what they cannot price,” explains David Downey, a spokesperson for OneChicago.
As a result, SSFs on ETFs, like ETF futures, have not taken flight – generating only a fraction of the volume anticipated.
However, change may be on the horizon. To eliminate ambiguity, OneChicago has engaged in talks with market participants, such as brokerage houses, to isolate the future deviations of the ETF SSF dividend stream so as to make forward valuations simpler. It anticipates a resolution in early 2010.
If this is successful, users of ETF SSFs will be able to evaluate several paths to market in their search for delta exposure, according to Downey. Then, he believes, “Users will more and more be attuned to the costs of funding both long and short positions and the value of the SSF alternative will become apparent.”
|The cutting edge of ETFs
Exchange-traded funds that use swaps rather than futures to build their exposure are not a new development, but are already extremely common in the shape of leveraged and inverse ETFs. These allow investors to obtain downside protection on a market segment, without the trouble of putting on a short position.
According to Bradley Kay, an ETF analyst at Morningstar, while the bulk of exposure in the $30bn leveraged ETF business is gained through OTC swaps, not futures, this may not always be the case.
ProShares and Direxion, substantial players in leveraged ETFs, are both coming out with products with monthly rather than daily compounding, so that Kay believes it is only a matter of time before they start using more futures.
“With monthly compounding, it will be a lower cost to replicate their portfolios using futures,” he says. “Furthermore, there will not be as much trading or as much advanced calculation about how the exposures are matching up with the proposed exposure.”
Like commodity ETFs, those that invest in currencies also use futures. ETFs based on a basket of currency futures, such as the PowerShares DB US Dollar Index Bullish and Bearish ETFs, have found favour as an efficient way to trade a trend in the dollar.
In a novel spin, there are also ETFs that have equity options as their underlying. The PowerShares S&P 500 BuyWrite Portfolio ETF and PowerShares Nasdaq 100 BuyWrite Portfolio ETF allow investors or financial advisers access to the BuyWrite indices via an ETF.
These are indices that capture a buy-write strategy – that is, buying a security or index that you believe will go up and then writing a call option on it at a slightly higher price. If you are right, you sell the investment at a profit. Meanwhile, the option premium pays you a little for making the bet.
With the BuyWrite ETFs, instead of having to go out and buy securities and write options against them, investors have a prepackaged product through which they can accomplish the same thing.