Modernize Your Portfolio With ETF Futures

By Hank King AAA

Exchange-traded funds - baskets of stocks traded on an exchange - were first introduced in 1993. Since then, the number of ETFs has exploded to include more than 300 different funds with more than $300 billion under management worldwide in 2007.

Stock index futures
were first introduced through the Chicago Mercantile Exchange (CME) in 1997. Since then, volume has increased on a yearly basis.

As of 2007, there are three different futures contracts traded on ETFs:

  • Standard & Poor's 500 depositary receipts (tracks large-cap stocks)
  • Nasdaq-100 Index tracking stock (tracks Nasdaq's top 100 non-financial stocks)
  • iShares Russell 200 index fund (tracks small-cap stocks)

The CME ETF futures not only offers investors access to premier, highly liquid ETFs, but also the capital requirements for this investment are far lower than purchasing an ETF. Read on to learn more about ETF futures and how they are used.

SEE: Introduction To Exchange-Traded Funds

ETFs and Futures
ETFs were created in the U.S. and Canada to offer investors products that were similar in scope to index-based mutual funds but were less expensive and more easily tradeable. ETFs trade like stocks, whereas mutual funds can only be traded at end-of-day prices, or net asst value. Also, ETFs offer tax advantages over mutual funds and can be shorted on a downtick.

SEE: Advantages Of Exchange-Traded Funds

Investors use ETFs as a quick and easy way to get exposure to a sector or an emerging market, thus changing their asset allocation. There are many different strategies that can be used with ETFs thanks to their flexibility, ease of entry and wide coverage of investment styles, sectors and geographic locations.

S&P 500 Depositary Receipts
Also known as the SPDRs, or spiders, the S&P 500 depositary receipt was the first ETF introduced in the U.S. It began trading in 1993 and by 2007, it was the largest ETF in terms of assets with just under $50 million under management. The S&P 500 depositary receipt is composed of the 500 stocks in the composite index and trades roughly 50 million shares a day.

Nasdaq 100 Index Tracking Stock
The Nasdaq100 Index tracking stock, also known as the QQQQ, first traded back in March of 1999. It is made up of the top 100 non-financial companies listed on Nasdaq by market capitalization.

iShares Russell 2000 Index Fund
The Russell 2000 Index is one of the world's major benchmarks for small-cap stocks. As of 2007, the Russell 2000 ETF trades more than 80 million shares daily and has more than $10 billion under management.

ETFs Vs. Futures on ETFs
There are several differences between ETFs and their futures counterparts, from the trading units to expiration to delivery. Let's take a look at some of the most important differences here:

Trading Unit
ETFs trade in shares, which are ownership in a trust or portfolio, whereas ETF futures trade in contracts of 100 shares that represent a legally binding agreement to buy or sell in the future at an agreed upon price and at some futures date.

SEE: Futures Fundamentals

Expiration
ETFs do not expire, whereas the futures have specific expiration dates.

Settlement
ETFs do not have settlement dates. Futures are physically settled, which means that sellers deliver the underlying ETF shares to the buyer at expiration. Any futures contracts offset prior to expiration will be cash settled.

Short Selling
Short selling ETFs requires borrowing shares from a broker and paying interest on the borrowed amount. Futures are not borrowed, and initiating a short position is just as common as a long.

Margins/Performance Bonds
With equities and ETFs, margin is the amount of money a customer deposits with a broker. Regulation T requires that investors put up to 50% of the value of the transaction and borrow the other 50% with interest. By contrast, futures' margins are a good faith deposit to ensure that market participants are legitimate. The amount of margin needed in futures will vary from product to product.

Type of Account
For ETFs, investors need a securities account; trading futures requires a futures account.

Transaction Settlement
For ETFs, settlement occurs three business days after the trade date. Futures are marked-to-market daily.

Leverage
ETFs may be leveraged if bought on margin only, whereas futures have inherent margin, which can be as high as 15:1.

SEE: Rebound Quickly With Leveraged ETFs

Regulation
ETFs are regulated by the Securities and Exchange Commission (SEC). Futures are regulated by the Commodity Futures Trading Commission and the SEC.

Contract Specifications
S&P 500 Depositary Receipts
One futures contract of the S&P 500 depositary receipts (SPY) is equal 100 shares of the SPY. The SPY expires on the two front quarterly expirations (after the first coming quarter) as well as two serial expirations. This means that there will always be at least three contracts trading for the ETF futures. The SPY is traded electronically from 9:30 a.m. until 4:15 p.m. EST. Settlement occurs on the third Friday of the contract month. The minimum price movement is one cent, or $1 per contract.

Nasdaq 100 Index Tracking Stock
One futures contract of the Nasdaq 100 Index tracking stock (QQQQ) is worth 200 shares of the Qs. Expiration is the same for the Nasdaq ETF as it is for S&P ETF. It also trades during the same hours as the S&P with the same settlement date. This should not be a surprise considering they trade on the same exchange.

iShares Russell 2000 Index
Everything is the same for the Russell except one futures contract is equal to 200 shares of the iShares Russell 2000 Index.

The Bottom Line
Before you invest in either ETFs or ETF futures, you should discuss your financial situation with an investment professional. That said, there are plenty of reasons one should consider investing in ETF futures; they offer investors alternative ways to invest in numerous indexes and provide hedging opportunities. Besides the lower capital requirements for futures, the ETF futures are also electronically traded, providing for fast and efficient ways to enter the market.

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