important benchmarks and there are unimportant benchmarks, benchmark
index derivatives are widely used in risk management applications.
For example, an investor with an actively managed small-cap
portfolio might feel that superior stock selection reflected in the portfolio
will provide good, relative returns over the period ahead, but that
most small-cap stocks might still perform poorly. The investor can
hedge the portfolio’s exposure to small-caps while capturing its stock
selection advantage by hedging the small-cap risk with a short position
in a financial instrument linked to the Russell 2000 small-cap benchmark
index. Available risk management tools for this application range
from futures contracts and equity swap agreements—to the shares of a
small-cap exchange-traded fund.
Derivative contracts have limited lives. Equity index futures contracts
will usually be rolled over about four times a year in longer-term risk management
applications. While risk managers could take futures positions
with more distant settlements, liquidity is usually concentrated in the nearest
contracts. Consequently, risk managers typically use the near or next
contract and roll the position forward as it approaches expiration. Similar
expiration provisions apply to most swap agreements, leaving the typical
derivative transaction with considerable “roll” risk—risk of adverse market
impact from rolling the hedge forward to the next expiration.
If a hedger uses ETF shares instead of futures, a risk management position
can be held indefinitely without roll risk. Of course, the open-end
nature of an ETF risk management or hedging position has other differences
from futures and swaps. There is an implied cost associated with the
expenses of the fund that may make the ETF a better short hedge, and there
may be tracking error between the ETF portfolio and the benchmark index,
but these are usually small considerations relative to fluctuating roll risk
and recurring transaction costs in a longer-term rolling derivatives hedge.
Exhibit 4.1 illustrates two snapshot cost analyses of long stock
index futures versus long ETF shares as one-year portfolio replication
positions. When these analyses were prepared (at different times), they
indicated that the ETF was the low-cost replication instrument of choice
for an investor who expected the position to stay in place for a year. The
assumptions used in these analyses were appropriate at the times they
were prepared, but any investor or hedger should evaluate current market
conditions before choosing between futures or swaps and ETFs.
More importantly, the risk manager needs to convert the analyses of
Exhibit 4.1 from a long-side to a short-side cost comparison with specific
data for the organization managing the risk. The reason the examples
in Exhibit 4.1 show long positions in futures versus long positions
in ETFs is that the expected costs and trading frictions associated with a
long position are about the same for nearly everyone on the long side.
On the short side, the management fee works in favor of the ETF short
seller, but, more importantly, the net cost of borrowing ETF shares varies
over time and among risk managers. In fact, a number of the costs
change over time and among market participants.
In estimating the net share borrowing cost or loan premium for a
short ETF position, we will not spend much time discussing the fund
management fee. Lenders who buy ETF shares to lend them will sometimes
be the marginal share lenders in the ETF market and when they are
the marginal lenders they should be able to recoup the management fee
as part of their securities lending revenue. When the marginal lender is
an ordinary investor, the ETF loan premium will be unaffected by the
management fee. The fact that the existence of the management fee
favors the short seller may stimulate ETF share lending efforts by thirdparty
securities lending agents working with brokerage firms and custodians.
“Recapturing” the management fee should effectively increase the
lending revenue on which agency lending fees are calculated. Generally,
the larger component of the securities loan premium is the net interestrate-
linked spread which the share borrower pays. For ETF share loans,
the total loan premium can range from near 10 basis points in a very low
interest rate environment to a maximum of about 30 basis points if there
is management fee recapture built into the loan premium. If the loan premium
rises above that level, ETF short sellers will begin to switch to
futures contracts and some investors will create ETF shares to lend.
The low end of this range is determined by the minimum administrative
costs of setting up a large securities lending program and implementing
only very large intermediate- and longer-term securities loans in this very
liquid and relatively transparent market. The high end of the range in this
particular market will probably be determined by the economics of persuading
large pension funds with index portfolios to switch from direct
ownership of indexed portfolios—with few individual stock lending opportunities—
to, say, SPDRs with substantial and relatively consistent lending
opportunities. In fact, an astute S&P 500 index manager will probably
handle this transaction for its pension plan clients at no extra charge. A
30-basis point lending fee might cover the expense ratio of the ETF, any
performance penalty associated with the way the ETF is managed,3 an offset
for any index outperformance the pension plan’s index manager was
obtaining and administrative costs.4 The works of Gastineau,5 Blume and
Edelen,6 and Quinn and Wang7 help us understand how these costs can
aggregate to as much as 30 basis points for an S&P 500 portfolio. The
maximum lending fee might be larger for smaller cap funds if fund shares
are created to lend, perhaps as much as 100–150 basis points for a Russell
2000 ETF because a good pension plan index manager should beat the
Russell 2000 by a substantial margin. At a loan premium in this range,
futures will be the short risk management tool of choice.
A more efficient8 underlying large cap index than the S&P 500 could
theoretically lead to a lower maximum lending fee and a tighter spread if
the index were as widely accepted as the S&P 500. For now, a 20 basis
point spread between low- and high-borrowing costs is as tight as it is
likely to get, but smaller lenders and borrowers will often see significantly
wider spreads and higher loan premiums. To see the short-side perspective
on an ETF versus stock index futures comparison, the reader should modify
the numbers in Exhibit 4.1 for a short ETF position by reversing the
effect of the management fee (the management fee is the same as the
fund’s expense ratio in most ETFs) and adding an annual loan premium
in the 10 to 30 basis point range to the cost of the ETF transaction.
Read More : How Do ETFs Work In Risk Management Applications?
