An investment partnership

Mike O’Brien, director of global trading, and Mike Cirami, co-director of global income, explain Boston-based global asset manager Eaton Vance’s distinctly collaborative approach to investing effectively across multiple markets.

Mike O’Brien, director of global trading, and Mike Cirami, co-director of global income, explain Boston-based global asset manager Eaton Vance’s distinctly collaborative approach to investing effectively across multiple markets.

How would you describe the structure and processes that support your investment strategies and products?

Mike Cirami:  The global income group manages a number of different strategies, including our flagship global macro fund, which invests long and short in sovereign assets, by which we can mean local bonds, emerging market bonds, FX, rates, sovereign credit, equity markets and some commodities. The global macro fund is our biggest and most flexible mandate, but we also run a short duration strategic income fund, an emerging market local income fund and a currency fund.

Mike Cirami largeMike Cirami, Eaton Vance

The Global Macro Absolute Return Fund, which invests in various asset classes on a global basis, has been running since 1990. Since 2007, we have offered it to the public for direct investment, rather than it residing within a mutual fund – the Eaton Vance Short Duration Strategic Income Fund – delivering foreign assets to the market on a risk-managed, long/short basis. It has something of a unique origin because it was designed without the demands that the distribution side of the organisation might place on a new product. So it’s rewarding when external demand turns out to be so strong. Similarly, we have been running an institutional emerging market fund for a year and a half, which has charted its own course, ignoring the benchmarks. So far, our volatility is a third of our competitors and our returns are better, so we will soon look to find out whether our idea is validated in the marketplace.

All of the products are managed by the same group of people and follow the same process. Our global income group has a staff of around 45, including: the PMs, analysts and research associates on the portfolio management and research teams; the trading team headed by Mike O’Brien; and a team of portfolio coordinators that work with the traders and PMs to implement the views. There is no separation between traders and PMs: we can all see each other across our desks and we all sit at the same meetings and discuss the portfolios.

Mike O’Brien: As well as the close proximity between portfolio managers and traders, our middle-office group sits on the trading desk to provide their expertise throughout the trading process. I’m sure Mike interacts with our middle office far more than the majority of portfolio managers elsewhere on the buy-side. Having our middle-office staff fully integrated into the investment process is a huge advantage, especially when we’re trading in more esoteric markets. I can see the walls between the middle and front office tumbling across the buy-side in the near future.

Does the nature of these funds make for relatively intensive requirements on the trading desk?

Cirami:  Yes and no. We try to keep the turnover of investment ideas to a minimum, typically taking a one- to five-year-plus horizon. But the implementation of a particular idea might require a lot of input; for example a five-year idea involving one-month currency forwards will generate 60 trades. Using relatively short-duration instruments to express long-term views offers the benefits of liquidity and optionality.

If you’re expressing a position using T-bills, you might be facing a maturity every week. And if you’re invested in Egypt, which we were prior to the Arab Spring, someone from the trading desk has to come in early on Sunday for the Egyptian T-bill auction day, so demands on the trading desk can be intensive.

Money managers are faced with both an uncertain macro-economic environment and a wide range of post-crisis reforms to financial market structure. Which has had the biggest impact on how you implement investment ideas?

O’Brien: Whether it is new regulations for OTC derivatives or liquidity problems in the corporate bond market or even equity markets, we are having to keep on top of huge changes, through meetings with regulators, brokers and other buy-side firms. Market structure is front and centre and a very important part of what we do.

Cirami:  I don’t worry about market structure changes because I know that Mike is. The guys on the trading desk know the investment strategy; they are participating in the conversations, telling us what is and what is not possible, and what is changing down the road. It is a great relief to those of us doing the research and generating the investment ideas that we don’t have to worry about these things.

If the trading desk wasn’t so closely integrated with the rest of the investment team, there would be speed bumps; you might find yourself at ground zero at the point where you wanted to execute.

O’Brien: It’s important to have an ongoing dialogue. If Mike is thinking about implementing an idea in three months’ time, we’re already thinking about the best way to implement it.

For any market, you need to know whether the investment idea is sound and what the potential barriers to implementation are, but it’s particularly important for emerging and frontier markets where access can be very difficult. PMs should not have to think about preparing their portfolios for future changes to the OTC derivatives markets. Because we attend the meetings that the PMs hold with their individual teams, we know the issues we need to focus on over the next six to 12 months that will be relevant to a specific portfolio.

Mike O'Brien largeMike O'Brien, Eaton Vance

PMs might enter an order into a system to send it the three feet to my desk, but nothing arrives that hasn’t already been discussed at length. Systems are critical for compliance and for risk and portfolio management reasons of course, but the trading desk already know the PMs’ views so well that if Mike says he wants to trade Poland, I already know whether it is long or short and which asset classes he want to get involved in.

Are the cost implications of changes to the fixed income or OTC derivatives markets influencing the choice of instruments used to execute investment strategies?

O’Brien: The cost of trading is going up and impacting the strategies we use, but we’re only at the start. One example is the use of interest rate swaps (IRS) to hedge rates. Trading IRS had barely changed in 20 years and then last year the introduction of central clearing and swap execution facilities (SEFs) increased the cost and complexity significantly. As a result, we’ve been monitoring the costs and benefits of trading OTC IRS versus swap futures, and have concluded that the latter are more appropriate for us, because they are more standardised, more transparent, and the initial margin requirements are lower. We explained the benefits to Mike and we’ve agree to move forward using swap futures.

Cirami:  Our mandate from clients is to focus on how macro-economic and political developments are driving risk factors and the value of particular assets. Whether risk premia are going up or down, we’re looking to take advantage perceived gaps between fundamentals and those underlying risk factors. The job of the trading desk is to enable us to implement those views. If implementation via an established route becomes cost prohibitive, the trading desk has to figure out different ways to express those same views.

What changes have there been recently in what and how you consume services from the sell-side?

O’Brien: On the execution side, we are keeping an open mind on market structure. Regulations such as Basel III, the Volker rule and certain other regulations are impacting liquidity, especially in the bond markets. While we might have previously sent an RFQ to one or more banks, now we are looking for more creative solutions to address these liquidity issues, both from banks and non-banks.

We’re also interested in some of the agency trading services that are emerging in the derivatives space. We haven’t dealt with inter-dealer brokers previously, but interaction with those firms in derivatives could lead to executing cash business. The way that we interact with the banks is going to depend on who is developing new innovative trading mechanisms. The old buy-side to sell-side relationship is evolving pretty significantly.

Cirami:  Because we’re involved in a lot of local markets, we have always had relationships with regional and domestic banks. Post crisis, those relationships have grown in value as liquidity has become more constrained at the big money-centre banks. Overall, our research process is oriented away from consuming sell-side research by the nature of our multi-year time horizon, but we still want to maintain access to certain economists or firms that can facilitate meetings with issuers.

With banks supplying less liquidity, notably in the fixed income markets, is it time the buy-side played a more active role in supporting liquidity?

O’Brien: It is very difficult to get the buy-side to change, partly because it is such a fragmented group of players. But I think you will start to see changes in certain derivatives markets which I hope will carry over to the cash markets. Buy-side traders think of themselves as price takers, but that mentality has to change. You have to think of yourself as both a price taker and potentially a price maker. A lot of new ideas are being proposed to match up interest, but the mindset of the buy-side is to always wait for the other side to show the interest and the price first.

The other problem now is that, with rates so low and one directional for such a long period, the buy-side often adopts a herd mentality: if one person is buying, probably everyone is buying. As we start to see a little upward movement and volatility in rates, the herd mentality will hopefully change.

I think the development of SEFs or multilateral trading facilities in Europe will greatly help the buy-side to get away from the price taker mentality. Even though it has been slow going so far, once we do see more activity on SEF order books, maybe it will spread to the cash market as well. We are willing to consider being early adopters of new initiatives, for example buy-side to buy-side trading in the emerging markets space, because we believe the industry has to work together to solve these problems.

More trade automation should mean more accurate execution performance measurement. How do you monitor performance across the asset classes and how do you ensure that you are using that data to optimise service to the PMs?

O’Brien: It will be beneficial when we can measure with more accuracy our execution quality in the derivatives markets. From a transaction cost analysis (TCA) perspective, the equity market provides tick by tick data on every trade, but with foreign exchange you have to make some assumptions. We are using a TCA service to monitor FX execution performance on a quarterly basis across various currencies.

Traditionally in fixed income you can describe how you achieve best execution, but you don’t necessarily have the data to actually measure it. As the OTC markets become more electronic and transparent, we will have some data to back up our theories when we talk to the portfolio managers about how to execute a strategy.

Cirami:  Inevitably, there are some things you can measure and some things you can’t. And it may be that the things you can measure aren’t as important as those you can’t, but they get attention of traders, PMs, boards, even regulators, just because they can be measured.

If you’re trading US$100 million of bonds at US$5 million a clip, you might be able to prove you’re getting a great price for each slice, but if you are also leaking information the whole transaction is not being executed as efficiently as it could.

O’Brien: I agree that you don’t want traders solely focused on making their TCA look good, but we have the tools and the data to address those concerns. There has to be more to trading than meeting a benchmark, so I think more data and greater transparency will be beneficial.

How have client expectations changed in terms of transparency of the investment process?

O’Brien: We have regular due diligence meetings with existing and prospective clients. I spend a lot of time going through our process in great detail with prospective clients, and that work continues when clients come on board. Because we’re involved in a lot of different markets, institutional clients spend a fair amount of time getting to know us and our processes.

Cirami:  Clients want to come on site and see the idea and deal flow and the interaction between teams. Conducting the necessary due diligence and having the right trading and settlement processes in place is a big part of investing effectively in global markets, so we’re happy that the vast majority of our clients are interested in getting that type of view.

End-investors have shown more interest in market structure issues in the last five years, with a particular focus on high-frequency trading (HFT) since the publication of Michael Lewis’s ‘Flash Boys’. What has been your experience?

O’Brien: Although HFT has been largely an equities phenomenon, we have had concerns in the FX markets. Toward the end of last year, we noticed that prices we were trying to reach would vanish before we arrived when using certain algorithms, so we stopped using algos for FX trades. There are a lot of similarities between equities and FX so we were concerned that HFT firms were turning to FX in response to lower revenues from their equity trading activities.

The Michael Lewis book provided a clear narrative on how HFT worked. I bought a copy for every trader on the desk because I thought it would help them appreciate that market structure issues can make a world of difference to how we trade on behalf of clients.

We want to see greater transparency in how orders are executed and I expect that regulatory changes in support of electronic trading as well as the growing size of the buy-side versus the sell-side will facilitate the end-clients’ demand more transparency.

Mike, how will your future needs of trading desk evolve?

Cirami:  I’d like our traders to continue to deliver on new markets, new assets and new issues that we might not be aware of on the PM and research side. As we look at more markets in more parts of the world, traders must be able to identify assets that are cheaper than comparable ones elsewhere on a timely basis. A similar but distinct need is for the trading desk to get us set up to trade in new markets. They’ve been working on trading local assets in Albania for example. This kind of work is critically important and will occupy a certain percentage of their time going forward.