Diversification is good for improving the risk-return characteristics of your investments. But investors don’t always have to buy a portfolio of actual stocks to diversify. The U.S. market has liquid equity ETFs and futures (as well as mutual funds) that allow investors to benefit from equity returns.
Investing in each is very different:
- Stocks require a lot of separate trades and cash flow management as dividends are paid and index changes occur, but there are infinite ways to weight portfolio holdings.
- ETFs have management fees and usually trade less than the stocks in their portfolio. But with over 2,000 ETFs, you can get exposure to different asset classes, countries, sectors, styles and even investment themes with a single trade and, often, very tight spreads.
- Futures require rolling as contracts expire each quarter and have the fewest number of choices for portfolio construction, with trading restricted mostly to broad-based large-cap (S&P500), Nasdaq-100 and small-cap (Russell 2000) index-weighted returns. However, they are cheap and liquid to trade and settle.
It turns out there is a cost-benefit to each. Weighing the best outcome is what a portfolio manager will do every time there is cash flow to invest.
Comparing trading in stocks vs. ETFs vs. futures
Today we focus on two things that traders often look at before they trade: spreads and liquidity.
- Spreads reflect the costs of doing an immediate trade. Wider spreads mean higher transaction costs.
- More liquidity means a larger investment can be made at the same time and, often, for a lower cost.
The data is summarized in Table 1 below.
Table 1: Comparing spreads and liquidity of stocks, futures and ETFs
The data shows that futures and ETFs have much tighter spreads. In aggregate, futures trade more than the underlying stock and ETF markets combined. For example, a select group of E-mini and Micro E-mini futures contracts alone traded around $628 billion per day over Q1 2021.
The daily liquidity of futures is also much greater than that of ETFs, but as we detailed below, the creation and redemption functions of ETFs mean that ETFs can (and often do) absorb very large transactions. For ETFs, “screen liquidity” is only half the story.
For investors, there is active debate about whether ETFs or futures are actually the “cheapest” to trade. The fact that futures are leveraged and need to be rolled often usually makes them more suitable for institutional investors, while the simplicity of buying and holding an ETF works for individual investors.
Ultimately, the fact that stocks have the most flexibility and good liquidity outweighs the wider portfolio-weighted spreads they have—especially for those looking to outperform the index.
For traders, a trade-off often exists.
Spread costs on stocks are typically largest, ETFs the smallest
When we compare bid-offer spreads, we see that buying an index-weighted stock portfolio typically requires crossing much wider spreads than trading an ETF or futures (Chart 1). On average, stock spreads are more than 10-times the spreads that popular ETFs and futures trade.
For example, the Russell 2000 (small cap) companies cost around 33 basis points (bps) to cross spreads in the underlying components, compared to less than 1bp for a comparable ETF basket and only 1.4bp for futures. We see a similar result for the Nasdaq-100 and S&P 500.
That supports other work we’ve done, suggesting that most of the trading in futures and ETFs does NOT cause stock arbitrage to occur, as it wouldn’t be profitable to cross stock spreads for an uptick in futures or ETFs.
Surprisingly, considering the lower liquidity of ETFs (see below), we see that ETFs are the cheapest spread to cross. That’s because many futures markets have set spreads, so contracts are tick constrained. For example, spreads in the S&P 500 e-minis trade at around one-tick wide, which means the 0.67bps spread is as cheap as those futures can get at current prices. Even the Russell 2000 futures trade around three ticks wide, or 1.4bps, which is around double the cost of the ETF spread.
Chart 1: Spreads across exposures for each product type
But stocks have a lot of liquidity
Spreads data makes stocks look more expensive. However, liquidity tells a different story. If we include all U.S.-listed companies, stocks trade around $475 billion each day.
Futures are also incredibly liquid, with S&P500 e-minis trading around $353 billion per day, much more than the stocks in the S&P 500, which together trade “just” $261 billion per day.
In contrast, the most liquid ETF in the U.S. is SPY, which trades an average of “just” $32 billion each day. However, that also makes it the most liquid stock in the market, with more liquidity than AAPL or AMZN with their $2 trillion market capitalizations.
QQQ, which tracks the Nasdaq-100, is the second most liquid ETF in the U.S., trading $16 billion each day. IWM, representing around 2000 small-cap stocks, is the third most liquid ETF in the U.S., trading almost $7 billion each day.
Note that this analysis excludes over 2000 other ETFs, some of which offer chances to add thematic or style alpha to a personal portfolio. We are also excluding liquidity from other ETFs that also track the indexes in Table 1. For example, IVV, VOO, & SPLG adds another $3.3 billion in liquidity due to S&P 500 ETFs.
Just because ETFs look less liquid doesn’t mean they are. Thanks to the ETF creation and redemption mechanism, studies show that very large trades in ETFs are still possible and frequently happen. However, when they do, the ETF is likely to trade closer to the far touch of the underlying stocks (offer for buy trade), negating some of the apparent cost advantages of the ETF.
Chart 2: Liquidity across index exposure by product types
Stocks’ liquidity isn’t index weighted
Another subtlety of the liquidity comparisons in Chart 2 is that not all stocks are equally liquid. In fact, when we look at the proportion of trading that occurs in each stock and compare it to index weights, we find that especially liquid stocks skew the basket’s liquidity away from index weights.
That makes it harder to buy an index-weighted basket of stocks than it seems, as the least liquid stocks will limit the actual liquidity available to invest at the index weights required to build a portfolio that matched ETF and futures exposures and returns.
Chart 3: Comparing stock liquidity to stock weights in the Nasdaq-100 index
The differences between stocks, ETFs and futures aren’t limited to liquidity and spreads; there are roll costs and holding costs to consider too.
But even when looking at just trading factors, we see that ETFs, stocks and futures offer very different costs and benefits.
Robert Jankiewicz, Research Specialist for Economic Research at Nasdaq, contributed to this article.