How to Beat the Rising Cost of Swaps

Institutions look to ETFs as a workaround.

December 3, 2014

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balance coin stackRegulators are trying to make derivatives safer through tighter rules and bigger capital requirements for institutions that issue them. The idea is to cushion the global banking system against the failure of big banks and to bolster the system against the kinds of risks that built up prior to the 2008 financial crisis.

However, by making futures and swaps safer, regulators have made it a bit more difficult for large investors like pension funds to reduce the risk in their own portfolios. Traditionally, institutional investors have used futures and swaps as an easy and cheap way to hedge their exposure to equities, particularly to broad indexes like the S&P 500.

But new regulatory requirements have made those instruments more expensive—and that’s made the cost of ownership rise for investors using them.

That has many institutional investors turning elsewhere for ways to hedge—and exchange-traded funds (ETFs) are on the list of alternatives for some. In the U.S., for example, the cost of ETFs is declining and that is making them a compelling hedging tool. As Reginald M. Browne, senior managing director at Cantor Fitzgerald in New York, told Pensions and Investments, pension funds and endowments don’t often consider the hedging cost of their own counterparty. “If a pension wants $1 billion in exposure to the Russell 2000, what will be the net impact of that trade? Have they considered both explicit and implicit costs?”

As Pensions and Investments reports, strategies like ETFs don’t usually involve a long-term counterparty that is looking to shed risk or compensate for it. For long investors aiming to fully fund their beta exposure, it’s possible to make up the difference in cost against a swap by lending ETF shares.

The shift to ETFs from derivatives is also being noted elsewhere. As Tom Lydon points out on ETF Trends, analysis from Bank of America Merrill Lynch shows that a long-term investor seeking $100 million of S&P 500 exposure could save $250,000 in annual fees by choosing ETF exposure over futures.

So how much could this save the average plan sponsor? And will it be enough to shift more plans into ETFs over swaps? I’ll wait for the next Greenwich survey to see…

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