Fixed Income Trading Desk Alpha Generation – Out of the Shadows
Traditionally, alpha has referred to the ability of portfolio managers (PMs) to generate excess returns from research, analysis, ideas, and overall portfolio management. Another source of alpha generation which is often underestimated is the trading desk itself, which through differentiated execution and greater involvement in the investment process can enhance returns and add immense value to their firm.
Trading desks can impact alpha in multiple ways, but it is the most meaningful if it can be quantified and articulated.
First, there is alpha preservation from transaction cost savings. Historically, this has been the trader’s focus given the relative ease of measurement. Having access to multiple pools of liquidity, ranging from traditional bank desks, to electronic pools of dark and latent liquidity, better liquidity data and multiple protocols, can be the difference between executing around the mid, or crossing the spread. With thousands of trades per year, this can alone be the difference between average performance and outperformance, especially in less liquid asset classes such as corporate and emerging market bonds.
Beyond traditional preservation, there is an opportunity for enhancing fund performance by accessing “invisible” liquidity – that is, liquidity not available or observable through the traditional channels. Trading desks are tasked with executing difficult and large orders, often in relatively illiquid bonds. These are orders that reflect the PM’s views and an associated future expected price move. For many of these orders, there is no observable liquidity, or no liquidity for the full order size – at least in plain sight. As a result, unexecuted orders will often result in actual losses, or forgone gains for the fund. But what if trading desks were able to execute some of these orders by directly accessing latent or reactive liquidity from their peers, which even though not observable with the traditional methods, is sizeable and very real. Liquidnet’s Virtual High Touch aims to help asset managers identify latent and reactive liquidity in the most efficient way, with more than 40% of volume in 2018 originating from latent and reactive liquidity.
Greater direct input in the investment process by the trader can generate trader alpha. As an example, a PM is seeking to buy a specific bond, but the trader identifies a similar bond of the same or different issuer, which results in a better risk adjusted return for the fund.
The last form of trading desk alpha generation for this discussion, comes from analytics. The combination of trader acumen with market data, alternative data, machine learning and real-time microstructure analysis, have the potential to arm the trader with insights and decision support systems not available to most market participants. The trader remains in the driver’s seat – but is now armed with more powerful tools to make better decisions. The result is a likely better execution outcome with a direct benefit to the fund.
The above are just a few examples of quantifiable alpha identified and sourced by the trading desk.
The corporate bond market structure of 2019 has created the potential for more disperse outcomes in execution than ever before. This in turn arms buy-side traders with the framework to turn the trading desk into a formidable weapon for their firm by having a direct and quantifiable impact on alpha generation. It is time for the trading desk to step out of the alpha shadows and take a bigger role in the conversation, as well as the alpha generation calculations.
Constantinos Antoniades, Global Head of Fixed Income