There are six major criteria buy-side traders need to evaluate ETFs, baskets, stock index futures and OTC equity swaps, according to new research b
There are six major criteria buy-side traders need to evaluate ETFs, baskets, stock index futures and OTC equity swaps, according to new research by TABB Group.
A new report – The Optimal Implementation: ETFs, Futures and Swaps – says buy-side traders must carefully preserve alpha to help rebuild their investment performance records in the post-credit crisis environment.
‘Most traders have a choice of trading vehicles to implement a given trade, from ETFs to basket trades, from stock index futures contracts to OTC equity swaps,’ says Laurie Berke, a New York-based partner at TABB and author of the report. ‘The goal is to find the optimal fit between the characteristics of the trading vehicle and the goals of the underlying transaction..
Berke explains that if a comprehensive piece of software could sit on the desktop and run a comparative analysis across markets and asset classes to tell a buy-side equity trader how best to execute that order, she explains, at a minimum that software must highlight the cost/benefit differential between trading stocks, ETFs, futures and OTC equity swaps.
‘To do so successfully, they would need to use six major criteria when choosing an implementation strategy: explicit costs, implicit costs, liquidity, operational complexity, counterparty risk and regulatory constraints,’ she says.
Unfortunately, though there is no software that traders can load to quantify fully which one of the six criteria is optimal for any given trade.
‘There’s no analytic that shows a comprehensive comparison of the relative costs and benefits of one transaction over another,’ says Berke. ‘And yet today’s trader has to know precisely how to compare the cost of an ETF to the cost of the underlying basket, all the while needing to understand financing and volatility charges included in the price of a swap transaction and the richness/cheapness of roll risk in the calendar spread on the stock index future.
‘A buy-side trader also has to understand which implementation choice is optimal given a trade’s duration, market liquidity, the portfolio manager’s strategy and restrictions imposed by the client or regulators.’
Based on conversations and data obtained through interviews with buy-side traders at both hedge funds and traditional asset managers, as well as sell-side swaps desks, ETF desks, program trading desks and ETF algorithm providers, TABB’s research examines tremendous growth in the number and types of ETFs globally and the dramatic increase in daily volume and AuM for the most active ETF securities. It also evaluates liquidity in the listed stock index futures markets and the continuing growth in the popular “mini” contracts used institutions and high-frequency traders. In addition, it covers the advantages and disadvantages of the OTC equity swap market, from customization and duration to pricing and counterparty risk.
‘While counterparty risk, basis points, volatility and liquidity and the ability to raise cash on-demand are all important today, selecting the appropriate asset class for a trade while staring down the barrel of fading assets under management and deeply wounded performance records requires adequate preparation and the correct choice of weaponry,’ says Berke. ‘For most buy-side traders, the artillery choice is the way to win the war. To be forearmed is to be informed.’
