Index Return Series Paper 2:

Pranay Dureja, Senior Specialist, Nasdaq Index Research & Development

This is part 2 of a multi-part series where we deep dive into the nuances of Index Returns. This paper will provide an overview of the mechanisms of equity futures, the purpose of the equity index futures market, and how rolling these futures into an index has made them viable for structured notes and insurance products. 

At a Glance:

• Futures are highly liquid derivatives with low upfront capital requirements and are primarily used to hedge and speculate on a wide range of financial assets.
• Technological advancements and retail accessibility have led to record volumes in Nasdaq-100® futures.
• The Nasdaq-100 Futures Excess Return™ Index allows for systematic, long-term implementation of Nasdaq-100 futures, enabling investors to access leveraged, pure play exposure to the Nasdaq-100 through Structured Notes and Insurance Products.

In the previous paper, we explored the various forms of index returns and broke down the difference between funded and unfunded indexes. To recap, there were three forms of index returns – Price Return, Total Return, and Excess Return – with Excess Return Indexes being unfunded. The reason Excess Return Indexes are unfunded is because their exposure is synthetically created through derivatives such as futures rather than organically created through direct exposure to the underlying assets. Although futures have a reputation for complexity, thoughtfully incorporating them into indexes can offer investors access to a more diverse set of risk and return profiles.

In this paper, we will dive deeper into what equity futures contracts are, when they are used inside of excess return indexes, and why/how they are implemented. In particular, we will focus on how E-mini Nasdaq-100® Futures (NQ) are used inside of the Nasdaq-100 Futures Excess Return™ Index (NDXNQER™).

How do Futures Contracts Work?

Futures contracts are agreements to buy or sell an asset at a predetermined price at a specific time in the future. Unlike most derivatives, these contracts are standardized and traded on exchanges, making them highly liquid and efficient to trade. The key feature of futures contracts is that they lock in a price now for a transaction that will occur later, which can help investors manage the risk of price fluctuations. Investors can buy futures contracts tied to equities, commodities, government bonds, and even cryptocurrencies. 

For a deeper dive on futures, check out the following resources:

• Futures Fundamentals: Futures Fundamentals is an industry-wide education initiative to provide accessible and introductory learning on derivatives marketplaces.
• Understanding Futures: A Nasdaq paper explaining the role and mechanism of futures.
• CME Group: For more in-depth futures education, CME Group provides accredited courses that can deepen your futures knowledge to a more institutional level. 

Like most derivatives, futures are used primarily for two purposes: hedging and speculation, offering three key advantages: 

1. Lower Upfront Capital Required: You can establish a large notional exposure to an asset through a futures contract with a fraction of the upfront capital. This is because futures only require you to post collateral on day 1 of a transaction, which is a fraction of your total asset exposure.
2. High Liquidity: Futures markets are often more liquid than the markets for the underlying assets they track, making them far more efficient to trade in large volumes.
3. Central Counterparty: Because all futures trades are cleared and guaranteed by a central exchange, there is no counterparty risk. This is unlike other derivatives, such as forwards or swaps, where there is risk that a counterparty is unable to meet the obligations of the transaction at expiry. By removing counterparty risk, that further improves liquidity in the futures markets. 

Collateral, also known as margin, is a “good faith” deposit that traders are required to post with a broker to open/maintain a futures position and cover potential losses.

Hypothetical Cash-Settled Futures Contract Exposure:

Source: Nasdaq

The above diagram showcases the experience of executing and holding a futures contract. Futures require the contract holder to pay/receive only the difference in value between the starting and ending price, rather than the total value of the asset itself. Doing so allows the contract holder to establish a position with as much as 50 times implied leverage, depending on the collateral requirements. In other words, compared to purchasing an asset outright, a futures contract holder can generate the same amount of exposure to the same asset with as little as 1/50^th of the upfront capital required.

The above diagram showcases a contract that is “cash settlement”. Futures contracts, when possible, can also be “physical settlement”, which allows the contract holder to receive the physical asset at maturity.

Additionally, one of the benefits of holding futures is that you can use cash equivalents such as Treasury Bills to collateralize a futures position instead of non-interest-bearing cash. We can differentiate between the inclusion and exclusion of interest earned on collateral by defining the type of return:

• Excess Return = (Ending Value – Starting Value)
• Total Return = (Ending Value – Starting Value) + Interest earned from collateral

NQ: The Role of Equity Index Futures

Futures contracts can be tied to various assets, but for equity markets specifically, equity index futures are the predominant type of futures used. For US equity markets, there are two index futures in particular that have seen widespread adoption: the S&P 500 E-mini futures (ES) and the Nasdaq-100 E-mini futures (NQ). The E-mini futures are futures contracts that are typically one-fifth the size of a standard futures contract, have quarterly expiry, and are electronically traded on the Chicago Mercantile Exchange (CME). Their relatively smaller size has made them a more flexible tool for investors and has led to the snowball effect of higher volume making the contracts extremely liquid.

Notably, NQ has been used as a proxy to hedge and speculate on both the broad US Equity Market and the “Magnificent 7”, which is a group of 7 stocks listed on the Nasdaq Stock Market® that have disproportionately driven market performance in recent years. Below is a chart illustrating how volume and open interest in Nasdaq-100 futures has expanded over the course of the 21^st century:

Source: Nasdaq, CME, Bloomberg. Data as of 12/31/2024. Open Interest on Left-Hand Y-Axis, Volume on Right-Hand Y-Axis (rhs).

The increase in futures trading volume likely arose from three primary drivers:

1. Technological Advancements in Trading Futures: With risk-optimized and regulatory-friendly electronic trading platforms, more powerful computational systems, and the introduction of AI-powered High Frequency Trading (HFT), trading higher volumes of futures became far more automated for institutional investors.
2. Increased Retail Accessibility: With the inclusion of commission-free trading, smartphone-app based platforms, and easier to access financial education, an increased number of retail investors also began trading futures and other derivatives. This particularly had a strong effect on the Micro E-mini Nasdaq-100 Futures, which were introduced on May 6, 2019. By being 1/10^th of the contract size of a traditional E-mini contract, Micro E-mini futures allowed for further accessibility to a retail audience already becoming more attuned to futures.
3. Nasdaq-100 Maturation and Adoption: At the same time, the Nasdaq-100 evolved into an increasingly important benchmark for US equity investors of all kinds, accelerating inflows and volumes across the expanding NDX® product ecosystem including futures.

NQ first helped revolutionize short-term futures trading, but longer-term investors and market participants were also looking for futures exposure extending beyond three months. 

NDXNQER™: An Index of Rolling Index Futures

Enter the Nasdaq-100 Futures Excess Return™ Index (NDXNQER™), created to provide rolling exposure to NQ active futures contracts. This index offers a systematic approach for determining when to “roll” to the next contract, thereby minimizing the need for manual adjustments. Naturally, this systematic approach has led the index to find success in financial products wherein long-term futures exposure is utilized to deliver a fully managed solution. In particular, structured notes and annuities have seen increased use of NDXNQER in recent years. 

Rolling Exposure refers to the act of periodically renewing an expiring futures contract such that an investor is constantly being provided consistent exposure to a specific type of futures contract.

How exactly does the index systematically roll futures contracts?

1. The active contract expires on the third Friday of the third month in every quarter – namely March, June, September, and December.
2. The transition to the following contract happens on the 5^th, 4^th, and 3^rd day preceding the contract expiration.
3. On each of those three days, one-third of the expiring contracts get replaced with the following contracts, as illustrated below:

Source: Nasdaq

4. In the scenario there is a disruption event on a roll day, two-thirds of the expiring contracts would be replaced.

Additional details about the methodology can be found here. Regarding the impact of the methodology on performance, the chart below illustrates the results:

Source: Nasdaq, Bloomberg. Data between 12/31/2004 and 12/31/2024. Index live date on 4/1/2024, with simulated (backtested) data used for prior dates. Index Value on Left-Hand Y-Axis, Difference in Index Value on Right-Hand Y-Axis (rhs).

An analysis of the past two decades indicates that NDXNQER has achieved over 90% of the annualized return generated by NDX, which itself has significantly outperformed the broader US markets during this timeframe. The performance gap arises from the difference in return type, where NDX is a funded price return index and NDXNQER is an unfunded excess return index. As explained in the previous paper, an unfunded excess return index subtracts the cost of financing the assets via leveraged futures positions, therefore removing interest rate exposure from an index’s return. In the futures world, this phenomenon is often referenced as the “cost of carry”. 

• For purely financial assets like equity indexes, the cost of carry refers to interest expense incurred while holding assets until contract maturity, which is factored into futures prices. Higher interest rates increase financing costs and reduce futures prices, explaining recent performance differentials between NDX and NDXNQER during periods of elevated rates. Importantly, excess return indexes exclude any interest earned from collateral that might offset the cost of financing the trade.

Because interest rates have a natural lower bound of zero, there will (almost) never be a scenario in which an unfunded excess return index would outperform a funded price return index. What, then, explains any investor’s decision to utilize NDXNQER over NDX? There are two reasons an investor would track NDXNQER via a financial product:   

1. Leveraged exposure to the Nasdaq-100 through an index-linked solution:

   Typically, a financial institution creating a product that employs significant leverage will link to the performance of NDXNQER over NDX. This is often done to make the product feasible for the institution to hedge (and therefore offer to clients) given the significantly lower transaction costs of index futures.

• For example, the Nasdaq-100 Max 30™ Index (NDXMAX30™) utilizes NDXNQER to provide leveraged exposure to the Nasdaq-100 inside of Registered Index Linked Annuities.

2. A more “pure play” exposure to Nasdaq-100:

   By utilizing an unfunded excess return index, an investor will strictly receive the performance of the Nasdaq-100 above the risk-free rate in the market. This often has the added benefit of securing more attractive terms in the financial product they are purchasing through. 

• For example, purchasing a hypothetical Fixed Index Annuity linked to the performance of NDXNQER will provide a higher cap or par rate compared to traditional NDX.

On a more theoretical note, every equity investment’s return stream can be dissected into variables according to a pricing model such as the CAPM, in which the risk-free rate plays a central role. Disaggregating the impact of interest rates enables certain more sophisticated investors to isolate investment return drivers unique to equities, otherwise known as the equity risk premium. Although the average investor may still consider NDX to be the most suitable index, there are distinct scenarios that make NDXNQER the more attractive, or even exclusive, choice for certain investor segments. 

Conclusion

Exploring equity index futures within excess return indexes shows that the benefits of short-term index futures trading can extend to long-term financial products. In particular, the low upfront capital requirements and the high liquidity of futures have made them the ideal vehicle for hedging and speculation by institutional and retail investors alike. As a result, Nasdaq-100 E-mini Futures (NQ) now serve as a useful proxy for both US Equity Markets and the “Magnificent 7”, driven by technological advancements and retail accessibility. With markets for NQ more robust than ever, investors have increasing opportunities to invest in this market through Structured Notes and Insurance Products linked to the Nasdaq-100 Futures Excess Return Index (NDXNQER).

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