Delivering alpha for the long term
by Dr. Robert Barnes, Global Head of Primary Markets & CEO Turquoise, London Stock Exchange Group
Q1 2020’s free-falling stock indices sent shockwaves around the world, wiping trillions off the value of major companies. But the sell-off is more sobering still when one considers the high and rising importance of equity returns to the long-term financial well-being of individuals. It has never been more necessary for portfolio managers to mine alpha from hidden gems and for buy-side traders to protect that alpha through efficient execution.
Equities have long been the bedrock of retirement savings, but their contribution has gradually magnified. Successive pension reforms mean millions of members of defined contribution schemes all over Europe are counting on equities to fund retirements. Until recently, equities, bonds and cash deposits have shared the weight of expectation. But low interest rates have eroded cash earnings. And while some fixed-income investments have delivered equity-like returns over the past decade, the sovereign bonds that added ballast to many a balanced portfolio are now in negative yield territory.
This widescale dependence on equities is not a new phenomenon. The Lamfalussy report that informed the original Markets in Financial Instruments Directive (MiFID) observed that employees would need to invest 20% of their annual salary to amass a satisfactory pension pot if the real rate of return was just 2%. The recent QE era has not only seen low inflation and negative interest rates, but also difficult conditions in which to make differentiated equity-market returns. With ETFs offering low-cost exposure to blue chips, the challenge for active managers is to identify tomorrow’s titans among today’s mid- and small-cap stocks, without sacrificing alpha through wide spreads and slippage costs.
Buy-side traders can also contribute to pension pots by choosing the most efficient routes to market. And MiFID II is keeping them honest through best execution requirements that make it easier for investors to compare execution costs and practices. But trading mid- and small-cap stocks on primary exchanges can be an expensive business. With limited liquidity, small-cap spreads can be much wider than for blue chips, with this difference being compounded when markets are volatile. And with average trade sizes on European exchanges at €10,000 and shrinking, natural blocks are few and far between.
The automation of equity markets has been a bumpy ride for the buy-side. Under MiFID I, low-latency-specific trading strategies were able to front run large orders in the same way that pit traders had done in open outcry. Nevertheless, partnership and innovation in market design is offering opportunities to trade efficiently beyond blue chips. Trading venues like Turquoise have developed market mechanisms that deliver on participant priorities shaped by the needs of end-users. These participants are looking to invest in stocks across the liquidity spectrum, in large size, with minimum slippage costs, and maximum transparency and anonymity.
In collaboration with the Plato Partnership, Turquoise has developed a market structure that reduces costs by minimising slippage and reversing the trend toward lower order sizes by giving buy-side traders the confidence to rest block orders without missing out on liquidity opportunities.
Turquoise Plato offers midpoint matching (relative to the best bid and offer on the primary exchange) not only in continuous trading but also utilising Turquoise Plato Uncross and Turquoise Plato Block Discovery. This means market participants use the same algorithms to combine the benefits of midpoint price improvement with the superior execution quality that derives from Turquoise Plato Uncross’s randomised execution functionality (which renders low-latency-specific strategies uneconomic) as well as the ability to interact with large, natural blocks.
The confirmation of ‘I would if I could’ messages resting in Turquoise Plato Block Discovery is designed to be immediate and automated, permitting only natural blocks to match. Combined with a limit price to protect against price drift, the anonymity and immediacy of the confirmation process gives buy-side traders a high degree of comfort to rest large orders, boosted by the knowledge they can still access liquidity elsewhere on Turquoise’s single order book.
It is the combination of these mechanisms, rather than a single silver bullet, which encourages buy-side traders to patiently search for mid- and small-cap liquidity on Turquoise Plato. Rather than crossing the spread in the hope of a quick deal, they see the benefits of waiting for natural liquidity, with lower spread costs, lower price reversion and larger trade size. This also supports future liquidity, as natural blocks can be reported immediately (due to absence of unwinding risk), adding to the price information available to other market participants. Over time, this helps to reduce future bid/offer spreads, especially in those crucial mid- and small-cap stocks.
The proof of the pudding is in the eating. The number of active stock symbols on Turquoise has increased steadily since 2015 within a diverse universe of more than 4,000 securities across 18 markets. Having trended gradually up toward 3,000 active symbols throughout 2019, it is interesting to note that activity continued to rise throughout Q1 2020. As highlighted in our previous blog, Turquoise performed with resilience throughout this period of extreme volatility, providing robust and orderly markets throughout, setting new records in the size and number of blocks traded.
It is our sincere hope that Turquoise can continue to support equities trading in Europe, including investment in the pension income of European investors and the capital raising plans of small- and mid-cap companies, whether listed in London or other markets within our tradeable universe. As international competition for listings intensifies, it is possible secondary market liquidity will become a more significant consideration, with market design and network distribution helping issuers to reach a global investor base.
Ultimately, portfolio managers must go wherever they can – across asset classes and borders – to find and extract alpha, as pressure mounts to deliver the returns demanded by demographic trends. Short-term shocks can assume exaggerated significance, but they can also be catalysts, signalling the future. To attract liquidity consistently, trading venue operators must offer the functionality and framework that helps buy-side traders to capture the maximum benefit of alpha for end-investors, whatever the weather.