SPY Serves Varied Portfolio Objectives Across All Market Regimes
Delivering on execution cost and risk
“When comparing execution cost, which is the bid-ask spread and impact relative to arrival price, and then execution risk, which is the price risk over the duration of the order, SPY showed material improvements in both categories versus its peers,” Ireland said. “Importantly, those estimated cost savings and improved trading performance became more pronounced as the size of the order increased. So the larger investors felt the benefits more on a relative basis.”
“For the period between March and April 2020, SPY maintained a basis point or lower daily average bid-ask spread, versus other S&P 500 ETFs that saw daily average bid-ask spreads widen to around six and seven basis points,” he said. “While quantifying the total cost of ownership depends on the size of the order, for order sizes of roughly $25 million, SPY’s speed of execution was 1/10th that of peers, with estimated execution cost significantly lower on a relative basis,” he added.
The active trading of SPY during that period of heightened market volatility pointed to investors’ comfort with the ticker, and Ireland said he expected that type of comfort level will persist in future periods of heightened uncertainty. “[We saw] that the implementation options for other S&P 500 ETFs are more limited on a relative basis [during such periods] because the spreads often reflect challenges in the underlying securities and the time for completion for large order sizes becomes constrained.”
Serving diverse objectives
Institutional investors relying on SPY’s liquidity in their core portfolio do so for myriad reasons.
“We often focus on different use cases that provide solutions to different investor types,” said Ireland. It’s a very wide spectrum of solutions: cash equitization for liquidity; derivatives strategies for hedging market risk; manager transitions to help maintain market beta; high-turnover strategies such as momentum- and trend-following strategies that rely on SPY’s secondary trading market; and the traditional buy-and-hold strategy.
Many institutional investors, particularly pension funds, today use SPY for cash equitization as it provides liquidity sleeves with the flexibility to make tactical adjustments. “In that context, the most common vehicle comparison for SPY is actually not ETFs, but futures,” Ireland said.
“In our opinion, SPY provides investment managers and, in particular, fully-funded pension managers, a far more operationally-efficient vehicle. The primary cost driver for index futures is implied funding, which is driven by supply and demand. And therefore, on a relative basis, SPY may offer a more stable cost structure.” he explained, noting that in the aftermath of the March 2020 market crisis, State Street saw significant interest from pension funds drawn to the SPY’s liquidity management benefits in the form of cash equitization and tactical flexibility.
“For pension managers seeking more control over the execution of cash equities, SPY may be an effective vehicle to facilitate that. … the [March 2020 volatility] sparked an evaluation of liquidity management in general and I do think that interest is going to continue.”
A wrapper for hedging purposes
SPY has long been utilized by hedge funds in futures and options strategies aimed at managing overall market risk, Ireland noted. “The depth of the listed options market provides a wide array of [SPY] investors the potential opportunity to hedge their portfolio effectively,” he said, adding that pension funds are now increasingly interested in SPY’s fungibility with derivatives. Some notable strategies in the last 12 to 18 months include the use of options on SPY to control for market risks; variable- and fixed-indexed annuities using SPY as a core building block or a hedging vehicle; and structured products that use SPY as a reference asset for specified return outcomes.
“One strategy where we’re seeing interest is a form of cash-and-carry arbitrage in which the investor would be long SPY and short S&P 500 futures to monetize the implied funding rate of the futures contract. This is a market-neutral strategy focused on earning a rate of return in the form of interest from the unfunded derivative contract,” said Ireland. “Historically, at year end, we see seasonal shifts that drive the futures implied financing rate higher. Currently, in the low interest-rate environment, we see [this strategy] as a very effective way for different types of investors to put cash to work; it’s a little bit more sophisticated but we have seen institutional investors become comfortable with it.”