According to new research from Deutsche Bank’s global equity index and ETF team, European ETFs tracking eight of the most popular equity indices have doubled in size since the end of 2007, while the open interest in futures tracking the same indices has shrunk by 30% over the same period.

Particularly strong growth rates have been registered by ETFs tracking composite indices with multi-country and multi-currency constituents, such as MSCI World and MSCI Europe, Deutsche Bank reports in “The Changing Face of Equity Beta Investing: ETFs, Futures and Total Return Swaps”.

However, the bank says that futures remain the “beta” vehicle of choice for the largest investors, with open interest in futures contracts still six times greater than the assets under management of European-listed ETFs based on the same indices.

If one includes US-listed ETFs in the calculation, though, ETFs’ overall size is nearer to half that of futures’ open interest, with the US$89 billion of assets in the SPDR S&P 500 ETF boosting the ETF market’s share.

One of the reasons for ETFs’ recent growth, according to the report, is that while futures and total return swaps are classified as derivatives, ETFs are fully funded equity instruments. In a period of increased vigilance and risk surveillance, ETFs have gained ground, especially with more conservative and medium-sized investors such as pension funds and high net worth managers. However, futures and total return swaps probably remain the beta instrument of choice for larger, more sophisticated and more demanding investors.

Futures are also probably cheaper, add the banks’ analysts. “Average major equity index ETF total expense ratios range between 30-50 basis points, while futures-related costs can be up to three times lower, or even generate positive roll returns, depending on prevailing market conditions. However, investors seem to be indifferent as [ETF] expense ratios are known in advance, whereas future spreads and roll costs are an unknown until they actually occur.” The operational simplicity of buying and holding an ETF, when compared to managing margin or reviewing swap documentation, also contributes to investors’ willingness to pay more for ETFs, the bank argues in its report.

Other activities undertaken by ETF managers, such as the optimisation of dividend-related taxes and the lending of securities, can help to offset ETF fees, Deutsche Bank points out. It is also important that investors understand how dividend payments are priced into the relevant beta instrument.

For ETFs, “in the vast majority of jurisdictions, dividend income is taxable,” write Deutsche Bank’s analysts. “The extent to which dividends are taxed differs greatly among countries. The level of taxation depends both on the ETF listing country’s taxation regime, as well as the domicile of the investor and their specific circumstances. Taxation is a complicated issue with unfortunately no global formula currently prevailing. Investors are strongly advised to seek tax advice.”

Some ETFs have more efficient tax treatment of dividends than their respective index assumptions, say the report’s authors. Dividend reinvestment assumptions for certain ETFs may also differ from that of their respective benchmark indices, they add.