Mercer Investments’ Stanko Milojevic explains how investors can avoid paying too much for transactions.
This is particularly evident in the credit markets, but also applies to some markets usually assumed to be very deep and liquid, such as the US treasury and German bund markets.
Investors need to think pragmatically about how they build portfolios to reflect the reality of a reduced liquidity environment
While bid-ask spreads – the most readily available proxy for transaction costs – have remained broadly unchanged during the past decade, reduced liquidity has led to a deterioration in market depth, meaning much smaller quantities of securities are available at quoted prices.
As a result, the price that traders see on the screen is seldom the price at which they are able to transact, as large trades often end up moving the market price.
This has contributed to periods of elevated volatility and an increase in the size and frequency of ‘gap moves’ (large price moves in a short space of time). So, while explicit transaction costs (measured by quoted bid-ask spreads) may not have increased significantly in recent years, the implicit costs associated with trading – such as market impact – have.
Handling liquidity
Financial markets are constantly evolving, and we are already seeing a number of developments that may act to counterbalance the challenges of reduced liquidity and its impact on trading costs.
For example, we have witnessed a degree of improvement in the transparency and growth of alternative sources of liquidity in the form of various electronic exchange venues, and some have argued that hedge funds are to some extent replacing banks as providers of liquidity.
In addition, innovations such as the standardisation of corporate bond instruments, making the market more similar to the listed equity and sovereign bond markets, and regulatory changes, may also help improve liquidity conditions over time.
In the meantime, investors need to think pragmatically about how they build portfolios to reflect the reality of a reduced liquidity environment. The key issue is that when the costs of trading are high, each trade directly eats into potential investment returns.
Transaction charges: What? Why? When?
From the blog:Debate about the disclosure of transaction charges has made waves across the pensions industry this year. Will the autumn bring a fresh set of challenges and paperwork for trustees and independent governance committees? Or is it possible to draw answers from information already out there?
This is particularly painful when risk premiums are reduced and many asset classes look fully priced. We believe that a number of important investment implications follow:
Size matters. Large funds may find it more difficult to implement changes to portfolio positioning without incurring significant costs or moving market prices. Prudent capacity management policies and the flexibility to use derivatives where appropriate are likely to be more important in this environment.
Avoid excessive trading. Strategies that require less frequent trading, such as buy-and-maintain credit, should be preferred over traditional benchmark-constrained strategies.
Be wary of liquidity mismatch. Any mismatch between the liquidity terms of a pooled fund and the liquidity of the underlying investments could create problems in stressed market conditions. The benefits of having a greater degree of control over the underlying portfolio via a segregated mandate might therefore be magnified in this environment.
Seek opportunity in volatility. Periods of market stress (exacerbated by reduced liquidity) may create opportunities for investors that are willing and able to behave in a contrarian manner. This supports the case for opportunistic and dynamic strategies, such as flexible multi-asset credit strategies, that may be well-placed to capture opportunities thrown up by market dislocations.
Embrace illiquidity. Investors with a long time horizon can embrace illiquid assets in order to access the broad and diverse universe of opportunities in private markets. Transaction costs in such markets have always been much higher than in listed markets, but this need not be a barrier for investors with a sufficiently long time horizon.
In summary, reduced liquidity and increased trading costs pose a challenge, but not an insurmountable one. Trading conditions could at some point improve, as market structures and participants continue to evolve. In the meantime, investors need to reflect the reduced liquidity environment in the way that they build portfolios.
Stanko Milojevic is an associate at Mercer Investments
