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JPMorgan’s annual ETF handbook landed last week, and as usual it contains some interesting nuggets. The one that jumped out to Alphaville was the relative liquidity of ETFs and futures at times of financial tumult.
The bank’s analysts examined the health of the respective markets in the wild swings of March and April, and spotted something very unusual.
During the bout of market volatility earlier this year, we saw a rare divergence between ETF and futures liquidity, with ETF liquidity steadily improving while futures liquidity deteriorated.
In March, the market depth — defined as the market order imbalance required to move the market by 1% in a short time period (e.g. 5 minutes) — of ES futures hit its lowest level since 2023, a trend that was also seen across asset classes and globally (outside of Europe).
ES refers to E-mini S&P 500 futures, which trade on the Chicago Mercantile Exchange, and track the same market as SPY, the SPDR S&P 500 ETF that has spawned its own rich ecosystem of derivatives.
You can see this “rare divergence” in the chart below.
ETF liquidity — or at least JPMorgan’s measure of it — did deteriorate, but only modestly. Meanwhile, futures liquidity fell off a cliff for some reason. As JPMorgan noted, this happened in both the S&P and Nasdaq-related products:
By the end of March, SPY ETF market depth was 61% above its 5y average. ETF liquidity did contract in April on the Liberation Day market volatility (SPY -37%, QQQ -30%), though SPY’s market depth remained in-line with its 5y average while QQQ’s was ~14% above its 5y average.
In contrast, futures liquidity contracted more severely, with ES down 53% m/m and 61% below its 5Y average, and NQ down 46% m/m and 53% below its 5Y average. This shift in relative liquidity between futures and ETFs may indicate changing investor preferences to trade ETFs in risk-off environments.
For the uninitiated, QQQ is Invesco’s Nasdaq 100-tracking QQQ ETF, while NQ is the mini futures contract targeting the same index.
So what happened? On the ETF side, it mostly reflects an increasingly diverse and vibrant ecosystem of participants that ensure healthy two-way markets even when markets are a little nauseous. SPY trades about $30bn of shares a day, and often much more at times of turmoil, with everyone from day traders to quant hedge funds often using it to “express their views”, as the argot goes.
Kenneth Lamont, Morningstar’s principal of research, reckons this development is likely to be repeated across a wider range of underlying markets as ETF adoption continues to accelerate. As he told Alphaville:
Futures can be incredibly liquid, but they have a tendency to dry up at certain times. ETFs generally have a broader investor base, so you have liquidity coming in from different directions.
It’s a big change. Futures have been the vehicle of choice for some time. If you want to go more exotic, the ETF gives you a broader range of products with some liquidity.
The more people using ETFs the better for ETFs. The more they are trading the more liquid they are, the more they become the single tool that everyone looks at. That improves the experience for everyone who uses them.
However, what caused S&P 500 futures liquidity to atrophy, and was it a sign of a secular change or merely a passing glitch?
Quite possibly the latter. John Burrello, senior portfolio manager of Invesco’s Income Advantage ETFs — a suite of options-based funds combining elements of covered calls and buffer vehicles — argues the futures market came under particular stress because of their rising cost.
As Alphaville highlighted earlier this year, spreads for long US equity market exposure via derivatives hit nearly 150 basis points in December, making it an expensive way for investors to get exposure to the US stock market. (Ironically, the rise of leveraged S&P 500 ETFs might be behind the elevated cost of futures, as they have grown rapidly lately and use E-mini S&P 500 futures for that extra juice).
The cost of funding had fallen back somewhat by the time of March’s market shenanigans, but at 70 bps it was still elevated compared to historic norms of around 40-50 bps, deterring many institutional investors according to Burrello. This fuelled the search for alternative trading tools such as ETFs.
The divergence between futures and ETF liquidity could also simply boil down to the fact that American retail investors — who overwhelmingly use ETFs — zealously bought the dip when markets turned rocky. Meanwhile, institutional investors, who are heavier users of futures, on the whole sold.
For Burrello, this is probably the best explanation for the bifurcation, and implies it might not be a durable shift:
I don’t think it’s quite as clear cut to say people are abandoning futures and adopting ETFs. It’s more nuanced.
