What does a bowl spaghetti have in common with the derivatives market pre-Dodd Frank? A lot actually, especially if you’re former U.S. Treasury Secretary Timothy Geithner, who calls derivatives a complicated tangle of spaghetti in his book, Stress Test: Reflections on the Financial Crisis. If derivatives are spaghetti, then I guess you could think of the Dodd-Frank Wall Street Reform and Consumer Protection Act as a big fork and spoon designed to tame those messy noodles into something an investor can actually eat—without getting red sauce all over his shirt.
Dodd-Frank introduced a host of new rules to eliminate the systemic risk in the derivatives market, including new margin requirements and electronic trading rules that add competition and transparency to the market.
And while these are good things for investors, Dodd-Frank has also added a few wrinkles for investors that rely on derivatives in their portfolios. It’s made the whole business a bit more expensive—and that cost has been passed onto investors.
The rising cost of futures trading is a challenge for many investors right now and apparently according to Reuters some large institutions—including endowments and sovereign wealth funds— are turning to exchange-traded funds to bring the cost of trading down.
Consider that before 2008 the average stock futures contract held for a year cost about $100 a year for a $100,000 contract value. That cost has risen to between $300 and $500 as bank dealers pass on the cost of higher capital requirements demanded under the new regulations.
ETF providers, however, are caught up in a fee war—prices are coming down and access has never been cheaper for investors.
So, according to Reuters, a long-term investor would pay $5 million (or 5% margin) for a $100 million futures contract on the S&P 500 and put the remaining $95 million in a money market mutual fund or cash equivalent. Every few months, when the contract expires, the investor has to roll it into a new contract.
Total costs according to Reuters at the end of the year would be $417,000 for that $100 million contract. If the underlying index moved up 5% the investor would get $4.58 million—a downward shift of 5% then the investor loses $5.42 million.
Got that? Now let’s look at the ETF example.
Put that $100 million into an S&P 500 stock index ETF for a cost of $164,000. If the index goes up 5%, the investor nets $4.84 million—if it drops 5% the investor would lose $5.16 million.
The numbers don’t work out the same for short-term exposure but for investors looking at the long-term, then it’s a compelling story and more evidence that ETFs are finding a wider set of users in the institutional space.