MiFID II has had an impact on small to medium cap (SMID) share liquidity, compounded by a retraction in related research coverage. Fewer fund managers following companies with reduced research coverage has led to lower effective rates of trading. This coincides with a time when the fund management industry has had more pressures, than ever, on the liquidity profile and returns of its portfolio
Equity investing is always focused on risk and return. However, liquidity is an additional variable in the equation that often goes unnoticed, unquantified, and underappreciated. In a large cap universe liquidity has less potential to impede the fund’s investment process and performance. In the SMID Cap universe, the importance of liquidity becomes more pronounced, particularly if it is made scarce. Indeed, many investors only truly appreciate its importance when it does become scarce and often too late.
Overall European equity volumes have been in decline since June 2018 leading to a reduction in liquidity across the market cap spectrum. A reduction in SMID cap liquidity has been more stark. The ‘Dear Chair’ FCA letter (dated 04/11/2019) on ‘Effective liquidity management: Good practise for Authorised Fund Managers’ and the subsequent reduction of SMID cap exposures and risk limits has had the largest impact. The highly documented liquidity crunches at numerous investment firms, and the short-term removal of these funds as potential liquidity participants, have also taken its toll. The market has also faced MiFID II, Brexit and a reduction in overseas appetite, the rise of ultra-low-cost passive investment and their associated execution strategies.
There are many factors as to why liquidity has become scarce, fragmented or more difficult to source. However, if potential liquidity exists, it is often an unwillingness to engage it or a misunderstanding of where it potentially exists that can have the most pronounced impact on fund performance.
A fund manager’s trading desk’s success and failure at sourcing necessary liquidity can be critical to a fund’s performance but often go overlooked. Such a desk can appear like it is ‘performing’ if the ‘headline’ cost of trading appears low and benchmarks such as VWAP, implementation short fall, basis points paid etc have all been bettered. These key performance indicators (KPIs) fail to consider other factors such as missed trades during the time it took to execute, delayed trades, the abandonment of the investment idea due to a perceived lack of liquidity or the price impact a chosen strategy has had on the identified investment.
The inclusion and importance a fund places on better understanding the execution function can have a material impact on these hidden and often ignored performance levers. A recognition of this ‘value add’ by trading desks is evolving within industry. The resurgence and integration of the execution function within the investment process has become increasingly important, particularly in the SMID cap universe, to help exploit liquidity opportunities in a more difficult and more restrictive volume environment.
A trading desk is having to work harder and think more creatively than ever before at how to identify and unlock liquidity. The more successful have the potential to add real alpha (outperformance) to a fund’s performance. However, the obsession to reduce headline execution costs or implement fixed and archaic benchmarks that monitor the trading performance can be counter-productive and overly restrictive of the behaviours best required in achieving an optimal strategy that interacts with potential liquidity.
Investment funds are getting better at understanding this ‘total cost’ of execution and the positive impact liquidity can have on the investment process. Some are tailoring their trading strategies to raise awareness and encouraging a willingness to engage with it. Sourcing multiple days’ average daily volume (ADV) with natural liquidity helps reduce market impact, save time, reduce opportunity cost and enhance your fund’s return. It is important that a trading desk has the support and the discretion to interact, the flexibility to pay a premium to participate in a ‘liquidity event’ and perhaps maybe a seat at next month’s investment committee.
Any equity trading desk should aim to provide their fund with superior and differentiated liquidity, more often, in these challenging times. The resurgent role of the trading desk higher up the investment process can unlock an often-untapped source of alpha. The role of the trader is becoming less about saving a few basis points on implementation and more about providing the insight and liquidity to give fund managers the potential to add full percentage points to performance.
By Glenn Dalton, head of equities, Goodbody