March 9, 2020 will be remembered by many investors – just like September 15, 2008, the day Lehman Brothers filed for bankruptcy. But March 2020 stands out even in comparison to the 2008/2009 financial crisis, as prices on European stock exchanges fell by almost 20% within the space of a week, a larger drop than ever seen before in such a short period of time. What was especially disconcerting was the fact that anyone who wanted to invest at more favorable prices at the end of March, after the crash, struggled to find investments without having to pay substantial premiums.
These developments are a clear sign that market liquidity is in decline – a common phenomenon in times of crisis as trading desks increase the bid-ask spread to reflect high price fluctuations. Some market players enter a complete state of shock, reducing market liquidity further.
Bond investors particularly felt the brunt of this in March. Especially in low-rating segments such as emerging market bonds or high-yield bonds, bid-ask spreads rose, in some cases to multiple percentage points. For example, the liquidity discount of exchange traded funds (ETFs) for hard currency emerging market bonds peaked at almost 8% in March, only to see a premium of over 2% a few days later (source: Bloomberg).
With such marked deviations from the actual valuation price, it is difficult to dynamically adjust the portfolio without suffering additional losses. This makes market liquidity so important for investors.
Liquid markets generally have five features:1
Narrow pricing refers to low transaction costs, e.g. bid-ask spreads. Immediacy describes how quickly orders can be carried out and settled and thus reflects the efficiency of trading, clearing and settlement systems. Depth indicates that there is an abundance of orders, both above and below the price at which a security is currently traded. Breadth means that orders can be executed both in large numbers and large volumes with only minimal impact on prices. Finally, resilience states how quickly new orders enter the market to level off market imbalances.
In a crisis, the market often moves away from these criteria. This then means that orders cannot, or cannot be fully, executed and the price may deviate substantially from the last trading price.
In fixed-income investments, the Bund Future is one of the most liquid instruments for investing in European bonds. Prior to the COVID-19 crisis, the bid-ask spreads for this were around 0.01%. Yet even this instrument could not evade the liquidity crisis in March. At the peak of market stress, the spread rose to almost 0.1%, with the order book depth also declining. Nonetheless, the Bund Future is faring far better than the cash bond market for global investment-grade corporate bonds. For futures, transaction costs rose much less and also fell again faster after the crisis peaked, as shown by chart 1.
The picture for equities is similar, albeit not so pronounced. The bid-ask spreads for European large caps equities prior to COVID-19 were around 0.03%, both for futures and for cash equities. Transaction costs picked up in March, with cash instruments seeing especially sharp increases (see chart 2). The only exception to this was on the trading day of March 18, 2020, when the daily average of the future’s bid-ask spread was higher than that of individual stocks. Nonetheless, we view this one trading day as a type of brief interruption to the liquidity advantage of futures and so it is not very significant in comparison.
When markets began to settle down, spreads for futures returned more quickly than the equities themselves and so efficient trading was reinstated here at an earlier stage.
Alongside yield and security, liquidity represents part of the “magical” triangle of investing. For many capital market participants, their principal focus in the run-up to the crisis in March 2020 was the yield of their portfolio, occasionally skimping on security and liquidity in order to generate sufficiently attractive returns. Institutional investors with long-term liabilities, in particular, frequently do not have very high liquidity requirements and can therefore accept illiquidity in their portfolio if this means they can expect higher returns and security. Yet even these investors should not be too reliant on illiquid investments. The market slump in March once again highlighted how important it is to ensure investments are somewhat liquid so that investors can adjust their portfolio if changes are made to the fundamental assessment. Ultimately, a good investment decision is worth something only if it can also be quickly and conveniently implemented.
This applies especially to systematic investment strategies. It is important that the prices included in the model are similar to the prices that can actually be traded.
The market slump in March and the liquidity shortage that this brought with it made it clear: exchange-traded futures are very well suited to systematic approaches.
Futures are standardized, listed instruments. As derivatives, they track the prices of underlying assets such as equities or bonds without investors having to physically possess these. Derivatives are futures, i.e. they require two parties to sell or purchase the underlying value at a fixed point in the future. As the transaction is concluded via a stock exchange, there is no counterparty risk. This increases the liquidity of the transaction – ultimately, a counter deal can be concluded with another partner at any time. In turn, the stock exchange uses various securities to protect itself against the parties defaulting. These take the form of an “initial margin”, which must be posted when executing a transaction, and a “variation margin”, which tracks changes in the transaction’s market value.
In a portfolio, futures can be used very effectively to increase and decrease capital market positions quickly and cost-efficiently.
The basic portfolio, which comprises the cash element of the portfolio, is built with bonds. These generate basic interest and serve as a security for the futures position. Futures in the requested asset class then form the active investment strategy. If the future exposure results in additional liquidity – if the futures have a positive market value – this is invested in the basic portfolio to avoid having excessive cash in the fund. Conversely, in the event of losses from the futures, part of the basic portfolio is sold to generate cash for additional securities.
Accordingly, it is important that the basic portfolio is designed with sufficiently high quality to ensure a flexible response is always possible. Key elements here are a short remaining maturity and high credit quality of the bonds in the basic portfolio. For this reason, the return of the basic portfolio is not a primary objective.
1. Measuring Liquidity in Financial Markets, Lybek, Sarr, IMF, December 2002. https://asean.elibrary.imf.org/view/IMF001/04583-9781451875577/04583-9781451875577/04583-9781451875577_A001.xml?redirect=true