Beyond Liquidity: Optimizing Product Selection (Greenwich Associates Study, 2018)

The number of financial products currently available to portfolio managers is impressive. While the financial crisis all but dried up the market for complex structured products, today’s more straightforward instruments can offer enhanced liquidity and eased access to the underlying markets. Many of these benefits continue to go underutilized, however, as conducting analysis to determine the most effective instrument choice for a given situation can be a daunting task.

From November 2017 to February 2018, Greenwich Associates interviewed 41 institutional investors in the United States and Europe to understand current practices relating to product selection and relative value analysis. One of the key findings was that portfolio managers and their trading desks primarily choose instruments based on past experience rather than through an analytical process. And while the accumulated knowledge of an experienced portfolio manager should not be undervalued, a move toward more systematic instrument selection could ultimately enhance fund returns by capturing alpha invisible to the naked eye.

Should you buy a bond or use an exchange-traded fund (ETF) or credit default swap (CDS) to gain that exposure instead? Now more than ever, analyzing that not-so-simple question on demand throughout the day could have an outsized impact not only on the portfolio, but also on the market as a whole.

Finding exposure

While challenging for the buy side, institutional investors are the beneficiaries of a more streamlined investment process than ever before. For example, measuring and working to improve best execution via transaction cost analysis (TCA) is nearly ubiquitous on equity trading desks and is growing rapidly with fixed-income and FX traders. This means investors no longer need to take a portfolio manager’s word that they’re achieving the best possible outcome—the proof is in the numbers.

However, for half of asset managers, that analysis of execution quality only examines how well the trader did with the exact order as given. For example, if the portfolio manager told the trader to buy $10 million in 5-year GE bonds, the trader’s success is based on the degree of improvement over the desired outcome for that exact bond—such as price, timeliness or lack of market impact. What remains underweighted in that analysis is whether or not buying that GE bond was, in fact, the most efficient way to get the exposure the portfolio manager was seeking.

Analysis for comparing instruments

Instrument choices today are numerous yet nuanced. There are many sources of credit exposure, for instance, all with their own benefits and drawbacks. For example, while derivatives provide leverage, top credit-focused ETFs are liquid and more closely track the indexes followed by bond investors. The ETF create-redeem mechanism has also proven to be a valuable source of liquidity, allowing bond portfolios as a whole to be traded much more efficiently. Nevertheless, making these choices on the fly is no easy task for the buy side.

An influx of fixed-income market data has finally made such analysis possible and actionable. Very few are leveraging this data via TCA and similar tools, however—less than one-third of study participants. And for those that are, the platforms and the value of the analysis they produce are perceived as in their infancy. Between corporate bond liquidity issues and a long list of product alternatives for gaining interest rate, credit, and equity exposure, only examining prices from a few counterparties or exchanges for a single instrument means investors are frequently leaving money on the table.

The way forward for product selection

To date, the instrument selection story has been one largely focused on liquidity, particularly for corporate bonds. Looking ahead, however, making such decisions intraday in a data-driven way will ultimately lead to better fund performance. Execution fees, collateral costs, market impact, and other implied costs can often be reduced by looking beyond the obvious choice.

Changing the mindset of investors and deploying technology to make that mindset change possible would be a complex process—both are easier said than done. However, solutions are starting to emerge, and some forward-thinking asset managers and dealers have already reshaped their approaches to their benefit. May the best product for each unique situation win.

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