This article is addressed to professional or semi-professional investors.
Although we are still a long way from being able to fully assess the economic impact of the pandemic and the new normality in our lives, the markets have put the first acute phase of the crisis behind them with remarkable speed. With this in mind, we may risk attempting to take a look back at this point. This review highlights once again the importance of meticulous, professional transition management for investors who need to restructure their portfolios in the current environment.
Public and economic life have slowed down due to the restrictions imposed by the world’s governments to contain the corona pandemic. These measures have had a severe impact on the global economy and have occasionally triggered panic-selling in the markets. The related extreme volatility was an expression of market players’ fears.
The loss of liquidity in a number of asset classes was the decisive factor for investors who felt forced to sell in these periods. Even asset classes that are usually regarded as liquid were affected. In some cases, trading was either not possible or could not be executed at the given quotes. In addition, there was a significant widening of spreads in a multitude of asset classes. The extent of this varied considerably, however.
Spreads of European corporate bonds and large-cap equities multiplied at their peak, while covered bond spreads widened by as much as 70 per cent. Trading costs (comprising spread and market impact costs) of shares in the S&P 500 also tripled at their peak. These developments reached a climax at the end of March 2020. From then on, the extreme volatility and the spreads gradually returned to normal.
The implications for investors varied according to the asset classes involved: stock market liquidity was mostly good. Those who needed to act could do so. However, trading was only possible with higher spread costs. This led to a sharp increase in transaction or implementation costs for funds, which in turn had a negative impact on performance.
Money market funds with strong credit holdings also saw increased volatility in the acute phase of market unrest. Only government bonds with good to very good credit ratings were consistently liquid - albeit with considerable fluctuations in their yields. The liquidity and tradability of one sub-sector of the government bonds stood out in particular: Euro Government Bills from core countries were anchors of stability and liquidity. They remained highly tradable with very tight spreads and strong liquidity even amid these extremely challenging market conditions.
We also saw increased demand for liquidity in funds with a high exposure to derivatives - in particular in CDS (credit default swaps). This increased rush for cash was largely due to calls on variation margins and to highly increased requirements on the initial margin as a result of the extremely volatile market conditions. Those who held highly-liquid assets in this period could count themselves lucky. Other investors faced liquidations and had to accept relatively high implicit costs.
Our observations are a result of pre-trade analyses which we, the Transition Management Team, carried out in response to investor enquiries regarding restructuring and allocation changes. The conclusion: Based on these analyses, we were able to put forward a strong argument for postponing the transition in the vast majority of cases between mid-March and mid-April where investors were not under any time pressure or other investment constraints.
"Postponing does not of course work in every case. If investors urgently need liquidity, they will be faced with substantially higher implementation costs in this kind of market environment. When market conditions improved considerably from mid-May onwards, we embarked upon 'parked' restructurings with a cost-efficient transition perspective," says Jürgen Winter, senior manager of the Transition Management team at Universal-Investment-Luxembourg S.A., Frankfurt am Main branch.
Provided that there is sufficient liquidity in the asset classes concerned, expert transition management can offer strong, risk-reducing restructuring solutions. It can ensure transparency and risk control at every point of the transition process. On average, about 60% of total costs can be saved . The key to reducing costs and risks effectively is to optimise the interaction of opportunity and market impact costs.
With this in mind, the focus is on two instruments and approaches: First, simultaneous cash-neutral trading, in which the illiquid side dictates the speed of restructuring, and second, overlay strategies, in which portfolio restructurings can be hedged. By using highly-liquid futures, the desired target allocation can be achieved very quickly, and opportunity costs can be drastically reduced. For example, a desired equity exposure can be built up very quickly using futures. At the same time, duration risks on the interest side can be eliminated using futures. During liquidity-optimised cash-neutral trading of the physical securities, the derivatives positions are then reduced accordingly. The main advantage of this approach is that trading can be carried out at an appropriate time and speed to reduce market impact costs.
1 Goldman Sachs Securities Division as of 20th April 2020.
Author: Thomas Casper
Date of issue: 7/24/2020
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