ETFs Vs. Futures: What’s The Difference?

What’s The Difference between ETFs vs futures? EU residents are not eligible for trading most US-domiciled/registered ETFs. Because of this, EU retail clients and traders are looking for alternatives: Are US futures or EU ETFs viable options and trading vehicles for US ETFs?

Furthermore, because EU residents are not eligible for buying and selling US ETFs, we discuss if US futures and EU ETFs are good trading vehicle instead of US ETFs. We conclude that the ETFs domiciled in the EU are not a trading substitute for ETFs domiciled in the US.

What is the difference between trading ETFs and futures?

We do most of our backtests on ETFs. The main reason for that is simplicity. Still, we trade many of the strategies by using futures, but it depends on the time frame of the trade. For short-term trading we do futures, for longer-term we do ETFs to avoid rollovers.

But most EU traders can’t trade US-domiciled ETFs. Should you trade EU ETFs or US futures instead?

We start the article by describing the main differences between ETFs and futures, something that should be handy for US-based traders:

ETFs vs futures: Leverage, margin, and capital

Futures only requires a margin deposit, sometimes as low as only 4% of the underlying value.

For example, if you trade the e-mini contract in the S&P 500 the current value of the contract is 215 000 USD, but Interactive Brokers only requires an overnight margin of 16 200 USD and an intraday margin of 11 300. Mind you, this is one the highest margin requirement in the business because of IB’s strict risk profile.

Opposite, with ETFs you can only get 4x leverage intraday and 2x overnight.

ETFs vs futures: Liquidity

The futures market is far more liquid than ETFs for the most traded contracts such as the S&P 500, Nasdaq, bonds, gold, silver, etc.

According to the webpage of CME the e-mini S&P 500 trades more in average daily dollar volume than more than all 6 800 ETFs around the globe combined.

In general terms, we would say the futures market is way more liquid, but they offer only a lot of liquidity in the front-end months (see more below).

ETFs vs futures: Access and trading hours

Most futures markets trade around the clock, some even on the weekends, mostly six days a week where only Saturday is closed.

ETFs follow the opening hours of the exchanges. You can trade “after hours”, but liquidity drops the more time away from the close or the open.

ETFs vs futures: Management fees

Futures have no management fees. Zero.

ETFs have annual management fees. However, they vary a lot. For example, SPY has 0.095% in management fees. This is low, but not the lowest. Unfortunately, the more illiquid ones can have up to 1% and even more.

ETFs vs futures: Hidden costs in ETFs and futures

A futures contract is a “bet” between the buyer and the seller. It’s a 100% zero-sum game. What one trader makes in gain, another must lose.

However, because it’s a derivative, a futures contract doesn’t own anything of the underlying assets it is tracking. It’s a standardized contract.

An ETF needs to own the assets it is tracking (some have synthetic replication, though). This means ETFs need rebalancing at certain intervals, and rebalancing equals costs in the form of slippage.

Moreover, some ETFs are leveraged, for example like QLD which tracks the Nasdaq with 2x gearing. Some leveraged ETFs have huge tracking errors because of the leverage:

ETFs vs futures: Tracking errors

The futures market tracks the underlying index or assets very closely with hardly any tracking error at all.

Some ETFs have huge tracking errors. This certainly applies to many ETFs that are leveraged. Over time, these deviate a lot from the underlying. However, SPY and QQQ track the indices very well and hardly differ.

ETFs vs futures: The futures markets have a long history, ETFs don’t

The futures markets have a longer history than ETFs. Because of this, they are tested through many market cycles.

The oldest ETF still trading is SPY which had its inception in 1993. Roughly speaking, most of the ETFs are established after the GFC in 2008/09. In other words, ETFs are a rather new financial innovation.

How will ETFs hold up during the next financial crisis? We don’t know because they are mostly untested. We suspect many of the illiquid ones might face problems because they are not more liquid than the underlying assets it owns.

ETFs vs futures: Tax differences between futures and ETFs

We are no tax experts and tax rates are dependent on your residency. But according to the CME Group futures offer a tax advantage for short-term trading for US residents.

ETFs vs futures: Slippage and commission for futures and ETFs

Most futures trade with a fixed commission per contract (depending on the broker, of course). Our experience is that future contracts have lower spreads than ETFs, but of course, depending on the instrument. SPY and QQQ have always only one cent in slippage which is minuscule. In a previous article, we argued that slippage is very low in liquid ETFs.

ETFs can both be traded per share traded or per transaction.

Because of the differences, what might be a suitable solution for you, might not be suitable for another.

ETFs vs futures: Value and size

The original S&P 500 futures contract has a value of 250 per point, meaning one contract is valued at 1.087 million USD (S&P 500 at 4 350). Because this excludes many small retail traders an electronic e-mini contract was created with only 50 per point about 20 (?) years ago.

But as the S&P continues to increase in value, the CME introduced an E-micro contract in 2019 with only a 5 USD multiplier. This means a micro futures contract today is valued at only 21 750 USD, and the current overnight margin at IB is only 1 800 USD!

ETFs are traded as share units and you can trade only 1 if that’s what your account allows.

ETFs vs futures: Longevity

Futures trade within a limited time frame and expire a certain times per year. The e-mini contracts for S&P 500 and Nasdaq expire in March, June, September, and December each year.

This means you need to roll over if you want to own it longer than the expiry date. Because of this, future contracts are only useful for short-term trading and not long-term investing. It’s purely a vehicle for speculating and offsetting risk.

ETFs are suited for buy and hold. This is for example what Warren Buffett recommends for most long-term investors: buy a passive ETF like the S&P 500 or a mutual fund that tracks the main indices.

ETFs vs futures: Account deposits

Futures trading requires lower margins and thus less capital in your trading account. The amount you “save” can be set aside for long-term appreciation, for example in ETFs or mutual funds.

With ETFs, you are binding capital that could (perhaps) be of better use elsewhere.

ETFs vs futures: Eligibility for trading

Unfortunately, EU residents are not eligible for trading US-domiciled ETFs as of today. This is due to EU legislation and red tape. The main idea behind the rules is to make investors better understand the risks with the products.

One of the side-effects is that more trade futures contracts, which for many mean increasing the risk because of the low margin requirements.

EU residents and US-domiciled ETFs

From 2018 most US ETFs are not an option for EU residents. That is unfortunate, but at least the option of trading E-mini and E-micro contracts is a viable one for the most traded products like S&P 500, Nasdaq, gold, and silver (and more).

However, you can apply to get a “professional” status at your broker. How to get professional status is pretty straightforward, but you need a big account. For example, at Interactive Brokers, you send in an online request and they look at it individually.

Can you trade EU ETFs?

Of course, you can trade EU ETFs, but you need to backtest and check the profitability first. If something works in US ETFs, they don’t necessarily work in EU ETFs. As a matter of fact, they are unlikely to work.

The reason for that is different closing times: Obviously, ETFs close at completely different times than in the US.

Another issue is liquidity. US ETFs are for the most part far more liquid than EU ETFs.

This means the only options you have, if you are based in the EU, are to change your status to “professional” or trade US futures.

For example, if the average gain per trade is 0.5% in SPY or QQQ, this equals 22 points in S&P 500 futures (ES) and 74 points in Nasdaq (NQ). You don’t need to run separate backtests for US futures if you already have an ETF backtest.

What you can’t do is to trade EU ETFs and buy them at the close EU time. This is a completely different ballgame than buying SPY or QQQ at the close US time. We have not tested it, and have no idea how this might work. The only way to find out is by testing, something we have not done.

Conclusion: Should you trade ETFs or futures?

This article has explained the main differences between futures and ETFs. If you’re a US resident you can choose to trade ETFs or futures, while most EU traders can only trade futures. If you’re an EU resident you can’t replicate the backtests by trading EU ETFs. This means the only other option is to trade US futures, which of course can easily be done (if your broker allows). But beware of the different risks between ETFs vs futures.

How do ETFs and futures differ in terms of leverage, margin, and capital requirements?

Futures trading often requires a lower margin deposit, potentially as low as 4% of the underlying value, providing traders with higher leverage. On the other hand, ETFs offer more limited leverage, with 4x intraday and 2x overnight.

Which is more liquid, ETFs, or futures?

The futures market is generally more liquid, especially for widely traded contracts like S&P 500, Nasdaq, bonds, gold, and silver. According to CME, the e-mini S&P 500 alone trades more in average daily dollar volume than all 6,800 ETFs globally combined.

What are the differences in access and trading hours between ETFs and futures?

Futures markets typically operate around the clock, including weekends, allowing for more flexibility. In contrast, ETFs follow the opening hours of the exchanges, with reduced liquidity during after-hours trading.

What are the regulatory differences between ETFs and futures trading, particularly in the EU and the US?

ETFs and futures trading are subject to different regulatory frameworks in various regions. For example, EU legislation restricts EU residents from trading certain US-domiciled ETFs due to regulatory requirements aimed at investor protection. Futures trading regulations may vary between jurisdictions as well.

How do risk management strategies differ between ETFs and futures trading?

Risk management strategies may vary depending on the instrument traded. Futures trading often involves setting stop-loss orders and managing margin requirements closely due to the higher leverage involved. ETF trading may focus more on diversification and asset allocation to mitigate risk.

How does market volatility impact ETFs compared to futures contracts?

Market volatility can affect ETFs and futures contracts differently. ETFs, particularly those tracking volatile assets, may experience price fluctuations, affecting investor sentiment. Futures contracts, being derivative instruments, may see increased trading activity during periods of high volatility, potentially leading to larger price swings.

What are the tax implications associated with trading ETFs versus futures contracts?

Taxation on gains from ETFs and futures contracts can vary depending on factors such as holding period, residency, and trading frequency. Futures contracts may offer tax advantages for short-term trading in certain jurisdictions, while ETFs may be subject to capital gains tax or other applicable taxes.