The big shifts: Street-level insights from the trading desk
Executive summary:
- The current market environment is presenting challenges for many institutional investors, who are struggling to manage around an overweight position in private markets and a resulting underweight position in public assets.
- The shift to T+1 is resulting in an uptick in liquidity after 5 p.m. Eastern time, which is known as the current witching hour.
- De-risking has emerged as a common theme among many institutional investors in today's market environment.
On 7 May, Jason Lenzo, managing director and head of trading at Russell Investments, led a discussion focusing on client portfolios and allocations and today’s market dynamics, as well as upcoming changes in the market cycle. Lenzo was joined by four colleagues from the Russell Investments implementation and trading teams: Lisa Cavallari, senior director of derivatives trading; Natsumi Matsuba, director and head of foreign exchange (FX) trading and portfolio management; Greg Nordquist, director of overlay services; and Brandon Rasmussen, director and head of fixed income trading.
Following are highlights of their 39-minute conversation. Periodic timestamps are provided.
Let’s start with the allocation to private assets. Greg, you have a really interesting view into client portfolios and their allocations, as well as the challenges this market environment is providing. What are some of the solutions that you're seeing from your clients and the portfolios and what you're able to provide? <0:48>
Nordquist explained that managing a fund with a large allocation to private assets can be challenging, because there are increased liquidity demands from capital calls and distributions and the actual weights can move quite far from target.
With the past few years seeing a combination of continued commitments and low distributions, he said many clients are struggling to manage around an overweight position in private markets and a resulting underweight position in public assets.
“There is only so much you can do in liquid markets – there is no silver bullet, but we work with clients to identify the best proxies as well as strategies to mitigate the impact,” Nordquist added. One example is using modest amounts of leverage to get the equity or fixed income underweights to target, minimising tracking risk of the public portfolio and overall beta exposure.
When distributions resume, one thing we’ve seen in the past is that many clients receive shares instead of cash and need to turn single stocks into cash to reinvest, he said. Those shares are often locked up and can experience price pressure as shares come off lock-up. <2:36>
Cavallari added to the conversation on hedging strategies. “There have been a number of different inquiries and challenges that clients have had, so each is very specific to this situation – the type of holding that they have or the risk that they're specifically trying to mitigate,” she said. For one example, she talked about a U.S.-based domicile client who had private equity exposure that turned into an IPO that was very successful overseas in Asia.
“How do you, in a very disciplined manner, take that exposure and then liquidate it to the satisfaction of the client? That's one example in the private equity space,” Cavallari said. Hedging strategies “run the gamut,” she added. “What has been really interesting is the volume and the uptick that we've experienced in that particular segment of the marketplace more recently.”
Lenzo turned to Rasmussen for his perspective: “Our research has indicated that there's fairly heavy self-pressure in the market in the first few days of these lockouts when they get settled and matured with the custodians. We work with our clients quite a bit to make sure we've got a fairly passive and effective way of implementing their guidelines that they'd like done so that we can retain most of that capital.”
The discussion moved to the impact of T+1 on FX. For background, in February 2023, the Securities and Exchange Commission adopted rule amendments to shorten the standard settlement cycle to T+1 for transactions in U.S. securities, including equities, corporate bonds, unit investment trusts, and exchange-traded funds. The Canadian securities markets have followed suit and have adopted a T+1 settlement cycle, which went into effect 27 May. U.S. implementation began on May 28. A few years ago, we moved from T+3 to T+2, so we have some reference as to the impact, but T+1 is uniquely different as we are now impacted by the global clock. Natsumi, can you provide some background on what is happening and the issues that we need to be aware of? <7:02>
Matsuba explained the shift, its implications and some of the challenges. “The shift to T+1 represents a shortening of execution and delivery time for market participants and presents additional challenges, especially for those that invest in the U.S. and Canadian markets with a non-USD/non-CAD operating currency,” she said. “There are additional hurdles for investors acquiring U.S. and Canadian equities with a local currency based out of Asia and EMEA (Europe, Middle East and Africa) – specifically around bank holidays in their local base currencies.”
With this change, market participants anticipate a shift in liquidity, where there will be an uptick after 5 p.m. Eastern time, known as the current witching hour.
After speaking to some major banks' FX desks, we know there are talks for staffing to be extended on sales and trading desks to accommodate this witching hour, she added. This will give market participants the ability to trade for a little longer, providing a chance at settling in CLS (continuous linked settlement) and meeting their custodian cut-off times.
Additionally, she said, pre-funding is not a popular solution, however, some clients are placing FX instructions prior to their equity trades being complete using an estimated amount to reduce any potential overdraft fees, should there be any.
From an exposure perspective, Greg, I think you've seen a really significant rally in the equity market, and in some cases, it's been quite narrow. Is that something your clients are concerned about and are they wondering: ‘How can we hedge this narrow rally that we've been experiencing?’ <19:58>
“The current market environment is attractive for hedging. Volatility drives options prices. The past few years have been a departure from the norm – it feels volatile, but interest rate volatility has been more of the story, while equity volatility has really been muted, so pricing on protection strategies is attractive relative to history and many clients are looking to protect as we are near all-time highs,” said Nordquist.
Other clients, many in the corporate DB world, have experienced improved funded status and have protected that by de-risking their portfolios. “We’ve seen many sizable de-risking moves and this is one of the benefits of having an overlay in place to affect the shift initially, and then transition the managers to the ultimate portfolio. This is particularly true with a glide path trigger – sometimes you get close but don’t hit, other times you not only hit the trigger but then hit another. The overlay is that top-level risk management that can happen very quickly and efficiently, buying time to move the assets after the fact,” Nordquist added.
That's a good segue into some of the underlying market dynamics that you're seeing, Lisa <23:48>
“We've seen a number of different inquiries as our teams have collaborated on situations specific to what people are actually trying to hedge and what they're worried about,” Cavallari said.
“It has been exciting to watch because I don't know that at equity market highs like this that we necessarily expected such low volatility to be paired with that, so it's really been a rather interesting environment.”
Overall, conversations with clients have been educational, she said. “We learn more about what they care about and then we're also able to share our knowledge about what is out there and what is liquid enough for a large institutional investor to employ primarily in the listed space, but occasionally in the bilateral OTC space,” Cavallari added.
Brandon, what are you seeing in the fixed income space? <27:22>
De-risking is a theme, Rasmussen said. “We're seeing a lot of clients moving from equities to fixed income. A lot of that move seems to consist in longer credit or longer duration, which could be supplemented by Treasury STRIPS.”
The discussion concluded with the panel addressing audience questions.
Question #1: If you have a large private equity exposure but have a sudden unexpected need for liquidity, are there any trading or overlay approaches that can help accommodate this? <31:56>
“As the private equity and illiquid portion of the portfolio grows … that liquidity challenge gets to be pretty immense and the best solution is staying liquid in terms of holding cash by using an overlay to keep that exposure so you can meet the capital calls and you can reinvest the distributions very quickly,” Nordquist said. Trying to run tight levels of liquidity with that unpredictable cashflow is just problematic, so you need to make sure there's ample liquidity in the rest of the portfolio. “That's really where the best optimisation is for keeping up with that liquidity,” he said.
Be strategic and plan ahead is what I'm hearing today. How about this second question from the audience: Are you seeing exposure shifts that are surprising or pointing toward opportunities? <34:46>
Nordquist said: “I think there's a lot going under the surface. De-risking in general – that trend has been pretty significant.”
Rasmussen wrapped up by stating, “I think it's really interesting seeing what's going to happen in some of these higher yielding assets. I think people are kind of watching and deciding, when should I start to lower that exposure amount? We're seeing some of that emerging market exposure go lower and high yield exposure get lower as well as it moves into more investment grade credit.”
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.