COVID-19 market volatility elevates ADR spreads around the world
by Rey Santodomingo, CFA, Managing Director, Investment Strategy, and Andrew Subkoviak, CFA, Senior Investment Strategist
The bid-ask spread—defined as the price at which a market maker will offer a security to a buyer minus what they’ll accept from a seller—is an unavoidable component of an investor’s transaction costs. This is true of all securities in all markets. Over the years as markets have evolved, trading has become easier and volumes have increased, resulting in a long-term trend of narrowing spreads that effectively lower transaction costs for investors. But as global volatility has increased due to the COVID-19 crisis, so have spreads. For American Depository Receipts (ADRs) alone, they’ve climbed four to five times higher than normal in Asia and twice as high in Europe and the Americas, by some estimates.
ADRs are securities that provide US-based investors with relatively easy access to foreign equity markets. Direct investment in foreign stocks typically requires registration in each market. Due to the costs—and, in some cases, higher information disclosure requirements—this isn’t an option for most investors. ADRs provide a convenient alternative and have become a popular method to gain international exposure at the individual security level. However, these securities often incur higher trading costs and offer less liquidity than other US equities.
The size of an ADR’s spread is related to the degree to which an ADR’s home country market hours overlap with US market hours. In Asia, where there’s no overlap with US markets, spreads are highest, historically averaging 40 to 50 basis points (bps). Average spreads in Europe (20 to 25 bps) and the Americas (10 to 20 bps) are historically lower. Amid the sharp daily and intraday swings associated with the COVID-19 crisis, market makers need to protect themselves by increasing the spreads at which they offer transactions.
Market makers often hedge this risk by short-selling securities to offset the exposure. Unfortunately, in response to current volatility, some foreign markets have instituted temporary restrictions on short sales, forcing market makers to increase spreads to compensate. As long as investor anxiety is high, we can expect these elevated spreads to persist.
Parametric manages many accounts for clients using ADRs to gain exposure to international markets. Access to the individual securities allows us to manage sector and country risk exposures carefully while providing customization and tax benefits through tax-loss harvesting. We have over 20 years of experience monitoring the spreads and costs of these markets and incorporating this data into our trading decisions.
During this period of heightened volatility, investors are still generally able to execute ADR transactions. However, due to the recent spike in spreads, it’s important to think carefully about the resulting costs of large contributions or redemptions.
COVID-19 revaluation rocks volatility markets
by Michael Zaslavsky, CFA, CAIA, Senior Investment Strategist
In the last four weeks, we’ve seen a chaotic revaluation of risk assets. The 12.9% equity market sell-off on March 16 was the third-largest ever, behind only Black Monday of 1987 and the Great Depression of 1929. On the same day, the VIX® surged 25 points, the largest financial insurance repricing in history, as markets digested the possibility of GDP contracting 30% quarter-over-quarter and unemployment hitting 30%. Against that backdrop, liquidity dried up as many leveraged volatility exposures were forced to cover at the worst possible time.
Making things more difficult is the fact that banks have never been more regulated. After big banks were crucified over the 2008 financial crisis, global regulators were given a mandate to prevent any future bank bailouts. As a result, banks are unable to provide endless liquidity and market-making when every single buyer becomes a seller on short order. Meanwhile, rising transaction costs have made US Treasuries almost untradable.
We believe it’s more crucial than ever to remain disciplined. The storm that we face today is scary, and the waves ahead look absolutely destructive. But we believe investors are able to earn a volatility risk premium, which measures implied versus realized volatility, precisely because the storm is scary. There’s nothing to gain from watching each and every single wave approach and pass. Rather, there’s so much to potentially gain from allowing the process to unfold naturally.
Our construction process has weathered the storm and stands to benefit as the repricing of financial insurance continues. We credit such strength to our diversification in option types (calls and puts), strikes (probability targeting), and entry and exit (calendar exposure). Our process targets options that have a fixed probability of expiring without a liability. This feature leads to an automatic safety margin adjustment in reaction to changing market regimes. We believe the forward-looking opportunity set has never been stronger. Premium collection has surged to five times the long-term average, and strikes have grown as wide as -18% to the downside on the S&P 500® and 16% to the upside. As a result, our current targeted option breakeven corridor is extremely wide.
There have been numerous headlines describing the collapse and liquidation of funds that were once touted as best of breed in the volatility space. The nature of short volatility is the generation of small, steady gains while bearing the potential risk of large but rare drawdowns. For this specific reason, we emphasize the importance of avoiding leverage through liquid collateralization when implementing under- and overwriting strategies.
Uncertainty begets volatility, and volatility begets further uncertainty. As this vicious cycle continues, we advise clients to capitalize on the opportunity to harvest premiums from the provision of financial insurance. At its core, the sale of volatility through options implicitly provides liquidity. That embedded liquidity is most valuable in a market that desperately lacks it.
Emerging market investors grab greenbacks and bet on China
by Greg Liebl, CFA, Senior Investment Strategist
Much like their developed peers, emerging market equities have seen a sizable drawdown over the past two months as investors grapple with the global effects of COVID-19. The MSCI Emerging Markets Index has fallen roughly 30% from its January 17 peak, easily putting it into bear-market territory and wiping out gains accumulated over the past three years. Foreign investors have yanked $80 billion from emerging market countries in less than two months, topping outflows seen during the global financial crisis.
This flight to safety has caused a massive grab for US dollars. The Bloomberg Dollar Index, which measures the greenback against a basket of global currencies, increased abruptly over the last two weeks, hitting record levels on March 20. Its strength is causing major headaches for the many emerging market companies and governments that borrow in USD, effectively raising their borrowing costs and leaving them desperately searching for dollars to repay their debts. The US Federal Reserve has opened up temporary dollar swap lines to provide liquidity for foreign central banks.
Equity markets are forward-looking by design, which largely explains the somewhat muted response we saw to the initial COVID-19 outbreak in China. The assumption at the time was that the virus would be a temporary hit to Asian economic growth but wouldn’t travel outside the region. As it became clear how wrong that assessment was, we’ve seen markets reprice lower in fear of the unknowns. It’s hard to see volatility softening until we get a clear signal that the virus is coming under control.
In environments like this, it’s hard to stop emotions from controlling trading decisions, whether from overestimating one’s ability to time the market or simply being overcome by panic. Instead we look to harness this volatility through predefined rebalancing thresholds that trim capital from today’s outperformers and redeploy it to areas of the market with the greatest room to run in the future. We’re seeing more opportunities to do this as each country reacts to COVID-19 in its own way, causing dispersion among local equity market returns.
One place to watch will be China, where equities have actually held up better than most. Investors are betting on a V-shaped recovery owing to the quick actions of the Chinese government. To the extent we see some glimpses of normalcy returning to the Chinese economy and an indication that large-scale quarantines can pay off, we could see more broad support return to the global market.
Time for plan sponsors to recalibrate their hedging strategy
March 26, 2020
by David Phillips, CFA, Director, Liability Driven Investment Strategies
Two main components contribute to changes in pension liabilities: credit spreads and Treasury rates. The relationship between these components may confuse investors in volatile periods. The impact of the COVID-19 pandemic illustrates that confusion.
Amid high volatility in equity markets, credit spreads and treasury rates are moving in opposite directions, with 10-year rates falling 1% and spreads widening approximately twice as much. Since the end of 2019, yields from AAA to A have resulted in liabilities dropping approximately 10%. During this same period, Treasury rates alone would have pushed liabilities roughly 10% higher—but spread movements alone would have pushed liabilities 20% lower. The result is a net decline of 10% but a 30% back-and-forth swing in liabilities on a gross basis.
It's worth looking at the asset portfolio in the same context: credit spreads and treasury rates, particularly equities. In times when credit spreads have widened or narrowed materially, equities have returned large negative and positive returns, respectively. The same is true now: Equities have returned about -30% since the beginning of the year. Taken a step further, as liabilities have fallen with widening spreads, assets have fallen as much or more, depending on the size of the investor’s equity allocation. Any additional credit spread allocation in the fixed income portfolio only makes things worse. At the same time, if the fixed income portfolio isn’t fully hedging against falling Treasury rates, assets dependent on treasury rates won’t fully offset the resulting increase in liabilities.
Consider two plans with a 50-50 mix of equity and fixed income, both starting at 90% funded. The first has fixed income allocated to credit; the second is allocated to Treasuries only. Credit has Treasury exposure as well as spread exposure, so the two plans have the same outcome resulting from rates. However, the additional spread exposure in the first plan can create a situation where the plan is effectively overhedged against spreads in conjunction with equities. In the case of the Treasuries-only plan, equities alone might cover all of the liability movement resulting from spreads, depending on the size of the equity allocation. If it’s too low, the plan may still need some credit spread exposure on the fixed income side. On the other hand, a high enough equity allocation allows for lower credit spread exposure in fixed income, which helps in this environment. It could easily be the case that the first plan could fall to 75% funded while the second would have fallen to 85%. In either plan, increasing the Treasury rate hedge without increasing credit spread exposure can improve the resulting funded ratio.
Recent markets provide a window into pensions’ alignment of assets to liabilities. Plans have an opportunity to see firsthand whether they’ve implemented LDI strategies effectively and where to make changes in the near and long terms. Market illiquidity may limit a plan’s ability to make these changes quickly. But sponsors can take comfort that they can achieve their desired exposures—either toward or away from credit spreads and Treasury rates—by taking advantage of a derivatives overlay solution that allows them to act nimbly now and later.
The relationship of movements between equities and credit spreads may continue for some time. The direction of these movements is sure to change at some point; it’s impossible to know when. In the meantime, understanding how surplus will change with movements in rates and spreads adds transparency to the outcomes we’ll experience in the future.
Responsible investors come to terms with COVID-19
March 26, 2020
by Jennifer Sireklove, CFA, Managing Director, Investment Strategy
In normal market environments, companies face pressure to be transparent about their routine business practices. This allows investors to assess the environmental, social, and governance (ESG) characteristics of the companies they hold. The perception of a poor record on income inequality, worker safety, and job security can be enough to raise red flags.
But this is far from a normal environment. The COVID-19 pandemic has brought new attention to these longstanding issues, forcing companies to change their methods of doing business as quickly as possible. Incorporating these changes into ESG research is only just beginning, with responsible investing experts taking their own deep dives instead of waiting for data to come to them.
One issue we see getting a special focus is the ability and willingness of companies to allow their employees to work remotely. Some companies have been slow to adopt work-from-home technologies and enable their workforce to use them on a regular basis. Thanks to COVID-19, investors may think of this slowness as less of an inconvenience than a safety failure. They may have a similar opinion of retailers that refuse to close their brick-and-mortar stores at a time when people in communities all over the world are under orders to remain at home.
These are just a couple of examples of actions that can help or hurt companies from an ESG perspective. Our advice to responsible investors has always been to construct a portfolio based on their own unique priorities and values, using the most objective information available. Unfortunately, objective information about COVID-19 responses is likely to be scattershot for some time. Just as patience is vital as we wait for the pandemic curve to flatten, it’s equally vital for responsible investors to wait for the ESG world to adjust to this new reality.
One way for active investors to take more immediate action is through proxy voting. Resolutions are typically added to shareholder ballots months in advance, with little room for new additions as the vote draws closer. Investors who are concerned about a company’s COVID-19 response should take a look at existing resolutions related to business continuity, health care access, and compensation protections. Proxy voting and shareholder engagement has the potential to start important conversations about positive and lasting corporate change.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.