Portfolio trading as a concept has exploded in the last few years, egged on by market conditions and volatility brought on by the pandemic and other macroeconomic factors. However, whether or not all firms are able to monetise the tool by managing risk effectively in today’s environment, is up for debate.
The concept allows traders to execute a basket of stocks in one single transaction, minimising costs and allowing traders to bundle less liquid or more difficult to trade instruments in with more liquid transactions.
Electronically, it is a relatively new phenomenon to the last four to five years, and the protocol has gained momentum alongside other forms of electronic trading that differ from request for quote (RFQ) protocols on multi-dealer platforms, as participants look to minimise their market impact and avoid information leakage.
Manually, however, the practice has existed for many decades using a laborious process involving excel spreadsheets and phone calls. Portfolio trades have historically helped many institutions to move big blocks of risk. The protocol appeals to the sell-side for several reasons, namely the fact that they can take a basket of securities and use them in other trades, special purpose vehicles (SPV) or, importantly, the exchange traded fund (ETF) create and redeem process.
The tool’s popularity has swelled in recent years, thanks to market conditions. A recent report by Valantic and Acuiti found that 60% of sell-side respondents had noted “a gradual and consistent increase in demand for portfolio trading services” in recent years.
For example, in Q3, Tradeweb reported $1.4 billion in portfolio trading average daily turnover in the US, up from $1 billion in Q3 of the year prior. In the same period, international accounted for $332 million in Q3 up from $311 in Q3 2022.
Fellow fixed income titans MarketAxess and Bloomberg have also seen the same year on year growth. Bloomberg has reported 60% year on year growth in the protocol, while MarketAxess reported $27.5 billion in total portfolio trading volume in Q3 2023, up 11.1% from $24.7 billion from the same period in the year prior. In light of the demand, all three platform providers have continued to expand their portfolio trading offerings to jostle for market share.
The current market environment is likely the culprit for this demand, creating a renewed interest in fixed income in general after many years of low and stagnant interest rates. The rates environment has also released constraints on firms such as insurance pension funds – which drive some of the largest transactions in the world – encouraging more demand for portfolio trading in today’s markets.
However, as this market has grown, use cases for portfolio trades have changed and now range from very small to very large trades. This has meant the requirements to be successful in this market have evolved as well.
Large portfolio trades can sometimes prove to be arduous for some sell-side firms that don’t have the balance sheet or capabilities to effectively warehouse and manage risk, something that has only been exacerbated by the rates environment the markets have witnessed throughout the course of 2023. Firms want to capture a whole trade, but if they don’t have the balance sheet to do so, what do they do?
“[Portfolio trading] has become a bit more bifurcated. The average number keeps going down because people are using it for all day every day little flow adjustments etc but the largest trades have become larger and larger to handle some of these pension risk transfers, for example,” Paul Glezer, global head of portfolio trading, JP Morgan, told The TRADE.
“What’s happened is the requirements to be successful in this business are no longer single mould. You have to be extremely nimble, have a massive technological systematic market making effort that leverages the algos and create redeem in the ETF primary and secondary markets … and institutional presence globally to be able to handle some of these large transactions.”
“We’ve leveraged a lot of their [equities franchise] work in terms of how they visualise baskets and look at risk and some of these toolsets especially on the systematic market side.”
Workflow adjustments
Central to a liquidity provider’s success in portfolio trading today is the ability to recycle risk across other products – a common theme seen across other asset classes and trading instruments. Almost three quarters of respondents in Acuiti and Valantic’s report said they were making workflow adjustments around more dynamic hedging tools to provide competitive portfolio trading services to clients, while 45% said they were upgrading risk management systems.
The players dominating this space consistently over time are the ones who have opted for a centralised risk management set up, namely the ETF market makers such as Flow Traders and Jane Street, and the bulge bracket investment banks that use a central macro or cash index desk to manage other index-based products and spread risk across other products.
As the market has experienced more volatility due to interest rate moves and inflation, market participants need additional ways to manage and hedge risk, using different securities, asset classes, and wrappers such as such as ETFs, CDS, TRS, or futures.
“We have one desk that trades fixed income whether that’s ETFs, bonds or portfolio. It’s one book and that makes it easy. That’s supported by automation to assess quickly what is the risk and how that works,” Flow Traders’ head of fixed income, Ramon Baljé, tells The TRADE.
“That’s versus a bank that has an equity department and a fixed income department. ETFs might be traded on the equities side and then bonds traded on the fixed income side. Then you have individual line traders as well so it takes a lot of coordination for a portfolio and that takes time.”
This is a workflow championed by several of the major bulge bracket institutions and it’s those institutions who are among best positioned to monetise the portfolio trading wave, particularly when managing large blocks, either through the portfolio trade itself or how it contributes to the bigger macro picture, Paul Kaplan, global head of credit, equities and TRS at Bloomberg, told The TRADE.
“Some sell-side have one trading desk managing risk across multiple different asset classes and wrappers. That centralisation doesn’t always guarantee you’ll do better, but it may allow for more efficient trading and management of risk. There may be some firms that aren’t realising the same value for various reasons,” he said.
“It could be that sell-side don’t profit as much on the PT, maybe they’re even flat on the PT, but they’re axed to buy a large block of securities and risk to create opportunity across the full ecosystem of asset classes and wrappers. Other sell-side shops may not have made that technology investment and may still source PT from each individual line desk. This might make it more challenging for them, in some cases, to trade and manage the risk.”
Other institutions have opted for a technology spend – backing an algorithmic approach to the management of risk. Around 64% of sell-side respondents said they were investing in new execution algorithms to be more competitive in portfolio trading in Valantic and Acuiti’s report. Algorithms sit centrally on the desk, pricing every line item within a portfolio, allowing for even pricing and better streamlining of communication across instruments and asset classes.
“A generic portfolio from a client will have a whole host of sectors and be very well diversified,” said one individual on the condition of anonymity. “If you were to ask multiple human traders who were trading those sectors to price that, you are a disadvantage because of potentially different risk outlooks and inconsistencies. Our consistency will always remain very strong because our portfolios price through the algo.”
The markets have seen a surge in fixed income exchange traded funds (ETFs) in recent years – a core theme at the Fixed Income Leaders Summits held across the globe this year and last year – spurred on by market conditions and demand from traders for lower risk access to the fixed income markets.
This surge goes hand in hand with portfolio trading which is often used by traders to simplify the create and redeem process. Looking to the markets of years gone by there were not many liquidity providers able to algorithmically price blocks of bonds in real-time but with the growth of ETFs this has changed and portfolios are traded off the create/redeem process daily.
“The next stage of development for us is a fixed income ETF market. It [fixed income ETFs] is such an integral part of how we view volumes and overall hedge the book because the balance sheet takes on a lot of different risk profiles,” said one sell-side individual.
Institutions are increasingly keen to accommodate clients and provide liquidity across as many products as possible to better hedge trade to manage risk and minimise costs.
“We’re trying to be in the middle of traditional institutional trading and fully systematic risk management,” Nick Adragna, co-head of global macro and investment grade trading told The TRADE. “We want to leverage our leading institutional franchise and we want to be able to always be there for our customers and keep the integrity of our cash business. At the same time, we want to have offer all outlets of liquidity for the growing number of smaller trades and be able to provide the liquidity to these customers.”
In light of the current market environment, demand portfolio trading has continued to grow. Changing interest rates have made efficient risk management capabilities essential for success in portfolio trading and while rate cuts are already being priced in for 2024, whether or not these will come to be a reality is a question for next year. For the time being, it seems only some players are in a position to effectively take advantage of swelling demand for the portfolio trading protocol.