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1 February 2015 CFA Institute Journal Review

Contracts for Dummies? The Performance of Investors in Contracts for Difference (Digest Summary)

  1. Clifford S. Ang, CFA

Investors use contracts for difference (CFDs) to leverage and short sell underlying assets. Using market order trades on the Australian Stock Exchange, the authors find that CFD trades earn a small positive return in the short term but negative returns in the longer term.

What’s Inside?

Investors use contracts for difference (CFDs), which are futures-like contracts, to leverage and short sell underlying assets. The global CFD market has grown rapidly, but CFDs are not available for sale in the United States because of SEC restrictions on over-the-counter instruments. Using market order trades on the Australian Stock Exchange (ASX), the authors find that CFD trades earn a small positive return in the short term but negative returns in the longer term. They also find that investors using CFDs to time their trades do not outperform those investing in a risk-free security.

How Is This Research Useful to Practitioners?

Given the regulatory attention CFDs are receiving in Australia, the authors provide a good introduction to the complexities and risks of the CFD market. CFDs offer investors the ability to leverage long and short positions underlying financial assets at low cost. Although CFDs are restricted in the United States, the global CFD market has grown in size. The authors report that in 2009, the CFD market in the United Kingdom alone traded a notional value of GBP602 billion. In addition, the target market for CFDs has expanded. CFDs were first marketed to institutional investors but are now being aggressively marketed to individual investors.

The authors are the first to report on the investment performance of CFDs. They find short-term outperformance after considering bid–ask spread and financing costs. Over longer holding periods of one month to one year, they find underperformance because of financing costs. In addition, they find that investors who time their CFD trades tend not to earn higher returns than the risk-free rate.

How Did the Authors Conduct This Research?

The authors conduct their research using CFDs listed on the ASX and their underlying stocks. The data for these instruments are obtained from Thomson Reuters Tick History and the Securities Industry Research Centre of Asia-Pacific. The authors use a sample of 71 CFDs, which consists of all the listed CFDs on the ASX, and use trade and quote data from 5 November 2007 (the initial listing of exchange-traded CFDs on the ASX) to 30 June 2010.

The following six steps are then performed to measure investor performance in CFDs. First, the authors identify buy and sell market orders by matching every trade to the prevailing bid and ask quotes and a zero-second time delay for trades. Second, on each day, the authors place buyer (seller) trades into a portfolio. Third, they calculate the abnormal daily return by subtracting the S&P/ASX 200 Accumulative Index return from the portfolio’s return over the holding period. Fourth, they calculate the daily buy-minus-sell portfolio return by subtracting the sell portfolio return from the buy portfolio return. Fifth, the authors calculate the average of the daily abnormal buy return, abnormal sell return, and buy-minus-sell portfolio return to estimate investor performance. Sixth, they incorporate transaction costs in the form of bid–ask spreads and financing costs.

The authors also investigate whether investors are timing their CFD trades by buying or selling prior to market upturns or downturns. For example, bullish investors may be net buyers of high beta stocks and bearish investors may be net sellers of high beta stocks. To test this, the authors calculate a daily market-timing return variable, which is equal to the trade-weighted average CAPM beta multiplied by the market return. They then calculate an excess market-timing return, which is the daily market-timing return over the entire holding period less the risk-free rate.

The study is limited to exchange-listed CFDs, which may perform differently from over-the-counter (OTC) CFDs—a fact that the authors acknowledge. As such, research on the trading performance of CFDs in the OTC market could be a potential avenue for future research.

Abstractor’s Viewpoint

Although the results of this research are interesting, they show that investors underperform in the short and long term from a practical perspective. In particular, the authors show that the short-term outperformance is eliminated once a brokerage cost of 10 bps is incorporated. Therefore, unless the investor can gain other benefits from using CFDs, the results suggest that, from a trading perspective, investing in CFDs yields lower returns than the average market order trade. But it may also be possible that OTC CFDs perform differently because of the ability to customize OTC contracts.

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