How to manage emerging market trading costs to improve returns

Published on 15 March 2021

The challenges of trading emerging markets (EM) are offset somewhat by the higher yields available, but even more so when the traders can mitigate trading costs through better execution approaches.

Spreads in EM bond markets are more affected during periods of volatility than developed markets, making the role of the buy-side trader vital in delivering investment goals. The traders themselves need access to the right data, the right relationships with dealers and the right electronic trading tools to find the optimal pathway to best execution.

Tom Nickalls, fixed income trader at asset manager Ninety One and Craig McLeod, head of emerging markets at MarketAxess outline the key elements that can help investors get better EM returns.

Dan Barnes Welcome to TRADER TV – your insight into trading for professional investors. I’m Dan Barnes. Investments in emerging markets is booming this year as people see higher yields. However, trading costs for trading in emerging markets are typically higher than for developed markets. Today, we’re speaking with Tom Nickalls, fixed income trader at asset manager Ninety One, and Craig McLeod, head of emerging markets at platform MarketAxess to discuss how buy-side traders are valued in the investment process.

Tom, Craig, welcome to the show.

Tom Nickalls Thanks for having me, Dan.

Craig MCleod Hi, Dan. Thanks, nice to be here.

Dan Barnes To start with, are trading costs for emerging markets funds actually higher in fixed income than they are for trading of developed markets fixed income?

Tom Nickalls On an aggregate basis, emerging market trading costs are higher than developed market trading costs, but it’s very, very simplistic to cover all of EM under one umbrella.

Craig MCleod EM fixed income consists of three separate debt classes and it spans across 30 very discrete economies. And the net result of all that is a real broad spectrum of liquidity. It’s constantly evolving.

Tom Nickalls Some portions of EM are extremely liquid. Chinese, local bonds, some portions of sort of Middle East IG credit, trading costs are very low and almost comparable to develop market counterparts. I think one point that sets EM apart is that during periods of volatility, the effect on EM trading costs is just a lot greater than developed markets.

Dan Barnes What are the causes of additional cost and which of those causes are manageable?

Tom Nickalls Your potential investors for a US Treasury are absolutely huge. If you look at EM potential investors, it’s just a lot smaller pool. So, you’ve got locals, your pension funds and the like. You’ve got dedicated EM money and then also kind of crossover tourist money, you could call it. Dealers have less places to go to manage risk, and as a result, bid offer spreads naturally increase. The volatility means they have to give themselves more of a chance to cover that risk without losing money. So as a result bit offers spreads widen.

Craig MCleod Volatility clearly does test dealer liquidity and dealer balance sheets. And during those times, even if we use the recent pandemic as a case study, clients tend to desire more liquidity options, so one of those options is the all-to-all marketplace where clients can obtain pricing or liquidity from institutional investors, domestic investors, maybe some of this tourist money that Tom alludes to. And a key benefit of that really is kind of cost savings. When you’ve got more participants contributing to liquidity, you’re not actually going to get better cost.

Tom Nickalls We are hearing of more crossover money entering the space and a general kind of search for yield. So that added investor interest should help us in the long run.

Dan Barnes How is a buy-side trader adding value to the investment process in emerging markets?

Craig MCleod Asset managers today are harvesting a significant amount of data and pushing it right to the start of the investment process. So what’s really happening is the marketplace is becoming a key part of the investment decision. And this data contains firm pricing axes, anonymous liquidity, smart and predictive data. And what this has done is really improved the likelihood of trading, reduce transaction costs and slippage.

Tom Nickalls EM markets are still very fragmented. So market color around flows, technical factors, particular liquidity squeezes, perhaps in different sectors or credit, is crucial for an EM trader to give this technical insight to create a more rounded view. The execution of large trades in these markets is also alpha generating. Making efficient decisions on which dealers to choose and who to partner up on in large illiquid securities is crucial to ensure that we get good execution outcomes.

Craig MCleod Trade automation is the first major building block to empower a trader to add value, and that’s something we’ve seen with our auto X capabilities at MarketAxess. Being conscious of cost saving benefits through open trading, but we’re starting to see these clients respond like a dealer for a open trading network. This has become so prominent we’re in the process of developing a bit of technology, what we call ‘autoresponder’, which systematically enables a client to respond through open trading, hands-off-the-wheel to reap these huge cost savings that they want to obtain.

Dan Barnes And then what challenges and risks do you actually face when you’re attempting to add value?

Tom Nickalls Improving trade data we get back from the fixed income markets, we’ve still got a long way to go on that front, but it’s improving all the time and feeding that back into the investment decision making to create that alpha generating opportunity. One thing I would say is that sell-side relations and have never been so important, so ensuring that we enhance them and foster them. Dealers have got balance sheet constraints and they need to be able to trust us when we trade with them to do things the right way. And that means those relationships are as key as ever.

Dan Barnes How do you see market structural changes affecting the execution choices that you have?

Tom Nickalls There’s a constant evolution of technology and regulation that we’ve got to be ready to adapt to. For example, all-to-all trading is increasing in market share. We’re also seeing a rise in ETFs, which is creating another technical dynamic to watching in credit markets particularly, and also ETFs are now becoming liquidity providers themselves. Investment banks are looking at different ways to interact with the buy-side, so we’ve just seen the acquisition of Liquidnet by ICAP as an example of that. So we need to be ready to kind of adapt to those types of changes to ensure that we’re still getting the best liquidity possible.

Craig MCleod Market structure fixed income is evolving faster than ever, and for the first time, I’d probably say regulation and technology are working hand in hand. And a byproduct of the interaction is the increase in available trade data, stimulating new marketplaces or new sources of liquidity. We recently launched what we call our live markets. So live markets is a central limit order book for credit that’s going to fold into emerging markets. So what’s happened is the increased available data is  it has enabled dealers to systematically price thousands of bonds to clients in real time.

Dan Barnes I want to talk about electronification of the markets. Clearly you’ve given some good examples of that. So presumably you see this leading to better execution choices, ultimately?

Craig MCleod Absolutely. You know, clients are spending a lot of time stretching the boundaries of e-trading. The discussions have really homed in on it, maximized by trading protocols and maximized by liquidity opportunities. So, fx recently, beyond the RFQ, we’ve built request for market, a two-way pricing protocol. It’s really familiar in FX, but now as an EM. We’ve also taken over participant pool and created what we call Mid-X, which is a session-based protocol, effectively it blends clients and dealers into anonymous auction, maximizing everyone’s ability to trade at mids. Those are really huge asks from our clients across the globe, particularly in EM. The third piece is portfolio trading; as indexation has increased, portfolio trading is only really starting to come to life just now in EM, but it’s definitely an emerging trend.

Tom Nickalls Building on the data we’re getting back is a crucial step and further electronification of markets will help. But we need to remember that sell-side relationships are as important as ever and electronification isn’t going to be a one size fits all. So we still need to remember that whilst we’ve got countless numbers of platforms to trade on, those close relationships with the sell-side are important, because we’re not going to be able to trade everything on electronic markets in the future, just like we can’t now.

Dan Barnes Craig, Tom, thank you very much.

Craig MCleod Thank you.

Tom Nickalls No problem, thanks for having me.

Dan Barnes I’d like to thank Tom Nickalls and Craig McLeod for their insights today and, of course, to you for watching. To catch up on our other shows or to subscribe to our newsletter, go to TRADERTV.NET.