The liquidity analysis tool has been developed to help the buy-side handle upcoming new dilution levy guidance – designed to act as a circuit-breaker to help ease volatility for the end investor – giving buy-side firms a more complete view of the liquidity of their equity portfolios. BEST EXECUTION spoke to Mark Montgomery of big xyt to learn more.
A dilution levy effectively protects investors from volatility by applying a charge to offset the transaction costs of cashflow activity. In the UK, almost all single-priced funds that do not have the ability to apply swing pricing (which enables funds to swing the unit price to offset transaction costs) are able to apply a dilution levy. The issue is coming to the fore given the volatility of the equities market over the past year, with the Investment Association, IOSCO and the FSB all recently issuing consultations or proposals around anti-dilution mechanisms – and with new guidance expected in 2024.
An understanding of addressable volumes is required to create a realistic ‘denominator’ for these dilution calculations – for example, only measuring the relevant liquidity that is accessible and excluding what is not. Sharing this data with banks and brokers (the traditional providers of pre-trade cost estimates) can also increase the risk of information leakage.
In response, and somewhat ahead of the curve, big xyt and Baillie Gifford have been working together to create a new solution, the Portfolio Liquidity Analysis tool, which automates the process of dilution application in a way that is data-driven and fair to the existing shareholders. When applied correctly, this should help investment managers minimise the impact of trading on a fund’s performance and apply test scenarios to evaluate the effect of more volatile conditions.
Trading data is used to calibrate the market impact estimates to improve the model fit and accuracy of the estimates (based on realised episodes of similar flow types). The market data model is responsive to changes in market conditions, allowing for accurate pricing in line with market conditions. The results are displayed in interactive web-based dashboards, with bespoke views can be created to meet a variety of industry needs.
“The problem is that if you’re a fund manager who wants to apply a dilution levy, you have numerous different inputs,” explained Mark Montgomery, head of strategy and business development at big xyt, speaking to BEST EXECUTION. “What was my portfolio yesterday, what was it overnight, into the next morning, and how have the holdings changed?
“Then to apply the levy you need to calculate what the spreads were, what the average daily volume is, and all the component parts that go into the market impact estimates. Then you have to apply it stock by stock across the whole portfolio, and then you might have to apply even more thresholds. Due to the very volatile circumstances over the past few years, we’ve been able to run a number of what-if scenarios. And in a big fund manager, what often happens is that the risk team will have to go to the trading desk, ask for information on what’s going on in the market, manually input the calculations into a spreadsheet, slice it in different ways, then go back to the client who might say, well OK, what will it look like in a week’s time, and then they have to start all over again. It’s an immensely complex process. What we have done is provide one automated process that takes away the key person dependency at each stage of the process, using technology to run it based on reliably sourced market data.
“Working on this solution in partnership with Baillie Gifford has provided a new turnkey solution for the buy-side. It addresses the major challenges faced by investment managers when managing portfolio liquidity, and reduces operational risk and user error with a robust yet streamlined process that automates dilution charges on a daily basis, which saves teams significant research time that can be used elsewhere.
“Speaking to market participants, it seems that most reasonably-sized asset managers have to deal with this issue and we are discovering that they approach it in different ways, nearly all of which involve manual gathering of data from multiple sources and the subsequent application of calculations, etc. (which can all be prone to human error). Therefore we believe that a proven approach, with the results made available systematically overnight, could be applied to any fund manager and remove an unnecessary headache.”
Although the product was launched today, the two firms have in fact been working on the solution for far longer, and Baillie Gifford has been using it to solve its dilution processes for most of the past year, making it a robustly tested product that is well ahead of the curve for the expected 2024 guidance.
“The partnership with big xyt was a collaboration between our trading and operations teams. Our aim was to create a robust dilution adjustment and a threshold process for large deals, that is in the best interests of our clients, with high regulatory standards,” explained Adam Conn, head of trading at Baillie Gifford.
A dilution levy might seem like unfairly penalising investors for wanting to exit a fund, but Montgomery points out that at the end of the day, it’s all about protecting the end investor and making sure everyone is treated fairly.
“If you suddenly do want to run for the hills, then it’s reasonable that if you’re on the other side of it, you will be treated fairly. And the other benefit is that if a dilution levy is applied, it might make people stop and think, and wait before they behave too aggressively, so that it doesn’t cost as much.”
With both IOSCO and FSB focusing on the issue, as well as the IA, it is one that is increasingly important for asset managers. In September 2023, BlackRock submitted feedback on both the FSB and IOSCO consultations, noting that: “We welcome the efforts of the FSB and IOSCO to ensure there is greater availability and uptake of a broad range of liquidity risk management tools (LMTs), particularly anti-dilution LMTs. Increasing the availability and appropriate use of these tools will strengthen funds’ liquidity risk management in all market conditions.”
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