(212 ( Portfolio Strategy Trading Less Competitive Markets is Costly TRADING STRATEGY Market Commentary 13 August 2013 Key Points Despite complaints about US market structure, it remains among the cheapest markets in the world to trade. In this report we compare global trading costs and find: Emerging markets are typically more expensive. Wider spreads account for most of the difference in costs between countries. Expensive countries are also more volatile at the single stock level. Emerging markets have a larger skew toward small cap stocks, which are more expensive to trade since they have lower volumes as well as higher spreads and volatility. Executing an index basket is even more expensive because illiquid countries have a larger weight than in that of a %ADV slice trade. Do this for your own universe in EDGE Our online pre trade tool lets you do all this analysis yourself, for whatever portfolios and trade sizing you want. For information on EDGE see: EDGE: Getting Started For details on the pre trade see: A New EDGE in Impact Cost Stephen Casciano + 212 325 0776 stephen.casciano@credit-suisse.com Phil Mackintosh + 1 212 325 5263 Phil.mackintosh@credit-suisse.com Trading Costs Vary by Country Despite complaints about US market structure, it remains among the cheapest markets to trade in the world, which benefits investor returns. In this report we compare global trading costs using our EDGE pre trade cost model and our ExPRT transaction cost database. What stands out is the importance of a competitive market structure in delivering low trading costs and ultimately better investor returns. We find that costs are lower in the US and developed Europe, whose markets are the most fragmented and competitive. Emerging Up to 3x More Expensive We compare expected costs across countries for a same size ADV slice trade. This shows that: Emerging markets are typically more expensive (green), and estimate that Morocco, Indonesia and Colombia are three times as expensive as Denmark. Spreads are also typically wider in more expensive markets, with Morocco, Indonesia and Colombia having the most expensive spreads and thus cost. Despite a high average stock price and very small tick size, US spreads are roughly in line with spreads across other developed markets. Exhibit 1: Expected trade costs by country (5% x ADV for all stocks in MSCI ACWI at 10% participation)
Actual Impact Cost Matches Model, but Skewed to Developed Markets Exhibit 2: Actual costs roughly match model by region - (1% x ADV for all stocks in MSCI ACWI at 15% participation) Exhibit 3: The model may overstate emerging costs Blob size indicates number of actual trades - (1% x ADV for all stocks in MSCI ACWI at 15% participation) Emerging markets have too few data points to analyze at the country level. Overall, the model overestimates. Not Enough Data for Some Countries, but Model Matches Actual Cost by Region We use our Edge market impact model to estimate the costs of trading across countries. Ideally, actual trading costs would be used, but not enough trading occurs in many countries (especially in the emerging markets) to provide meaningful results. However, when we group by region, rather than country, we have enough data to analyze actual costs (See Exhibit 2), and it s clear that the model matches the actuals reasonably well. The model slightly overstates Developed Europe, Emerging Asia and Emerging Europe, likely for a few reasons: 1. The model is based on an index basket, which has a higher concentration toward illiquid markets than the actual trade data, resulting in higher cost estimates. 2. The model is fit using real trade data. Because there are far fewer trades in the emerging markets, the model gives greater preference to developed markets (more on this below). Actual Costs Match Model in Highly Traded Countries, Overstated in Emerging Markets Because trading activity isn t spread evenly across countries, actual cost data is misleading for certain markets. Large outliers skew the average and don t represent the actual trading environment in countries with too few data points. Exhibit 3 shows that in countries with large amounts of trades (United States or Japan), represented by the larger blobs, actual costs roughly match the model s estimates. Countries where there is a mismatch between the model and the data, such as Malaysia, have smaller blobs, meaning fewer trades. We ve shown in Market Impact: Model vs. Reality that our impact model uses spreads and volatility to estimate costs accurately, giving us confidence that using the model for country-level analysis gives meaningful results. If there is a bias, Edge may be conservative for Developed Europe, Emerging Asia and Emerging Europe. Although emerging markets appear to be overstated in Edge, they are still more expensive than most developed markets. 2
TRADING STRATEGY Spreads Are Wider in Emerging Markets There is a direct relationship between spreads in each market and the expected costs of trading in that market. It s also clear that emerging markets tend to have wider spreads, on average, than developed markets. Both trends persist, even at the stock level. Exhibit 4: Spreads are closely correlated with market impact costs, even at the single stock level - (5% x ADV for all stocks in MSCI ACWI at 10% participation Volatility Also Higher If we compute the average stock volatility, we see emerging markets tend to be much higher. Although this seems intuitive, many investors might be surprised to know that the beta of the emerging markets index is just 1.08. Exhibit 5: Emerging markets are significantly more volatile than developed markets Exhibit 6: Like spreads, volatility is closely related to trading cost - (5% x ADV for all stocks in MSCI ACWI at 10% participation 3
Market Caps Are Lower in Expensive Markets Emerging markets stocks typically have smaller average market cap. Exhibit 7: Expensive countries have lower market caps and, once again, these are mostly emerging Trade Size by ADV Should Neutralize the Market Cap Dispersion Because the composition of every market is different, it s almost impossible to neutralize all the non-market-structure variables that contribute to cost. This is obvious for market cap in the chart below, which shows the market cap breakdown of each country (if we assume (large cap > $4bn and small cap < $1bn, see: Just How Large Is the Global Securities Market?). Remember that the MSCI ACWI index is designed to cover the top 85% of market cap in each country. If we use a global cap-size definition we see that some countries tend to have more small stocks than others, most and that this is exaggerated for emerging markets (toward the left side). Therefore, we compute expected costs for the same ADV for every stock in the MSCI ACWI index. This helps ensure an apples-toapples liquidity comparison across different markets. Using a percentage of ADV for each stock should minimize the impact of smaller stocks, or fundamentally less liquid markets, in terms of their expected impact. However, most investors run portfolios that more closely match the market cap spectrum, so although trading a percentage of ADV slice may help reveal which countries have more efficient microstructure, it probably doesn t reflect the actual cost profile of most trades. This is because analyzing a percent of ADV slice will understate trading in less liquid markets, which we explain in detail in the following section. Exhibit 8: Market cap breakdowns vary across countries 4
Market Cap Trade Exaggerates Differences Because different markets have structurally better (or worse) liquidity, the execution profile of an index trade is very different to the trade we analyze above. Exhibit 9: Emerging markets are also less liquid overall Source: Credit Suisse Trading Strategy The same size relative to ADV trade above is equal to around $US8bn. Executing an $US8bn index-weighted trade would require sizing up illiquid stocks and reducing liquid positions. Because emerging markets generally have lower liquidity, the cost differences for real investors are magnified. For example, indexers expected shortfall increases by nearly 10% versus a liquidity-weighted trade of the same size. The cost increase is clear in Exhibit 10a, where the emerging market cost estimates cluster in the upper right (large trade size, higher cost) It s clear from Exhibit 10b that a material portion of the single stock trades in an index-weighted trade have very high cost. To avoid these costs, investors can optimize their baskets to exclude these stocks while still matching the exposure they seek, especially since illiquid stocks are likely to account for less weight in the basket. For more on global equity market size and shape, see: Just How Large Is the Global Securities Market? Exhibit 10a & 10b: Executing an index weighted basket is more difficult because illiquid positions are larger Emerging markets trading is typically more expensive. A large number of positions have very high cost (>30bps). - (5% x ADV for all stocks in MSCI ACWI at 10% participation 5
Credit Suisse Trading Strategy USA Phil Mackintosh +1 212 325 5263 phil.mackintosh@credit-suisse.com Victor Lin +1 212 325 5281 victor.lin@credit-suisse.com Ana Avramovic +1 212 325 2438 ana.avramovic@credit-suisse.com Stephen Casciano +1 212 325 0776 stephen.casciano@credit-suisse.com Europe Mark Buchanan +44 20 7888 0908 mark.k.buchanan@credit-suisse.com Colin Goldin +44 20 7888 9637 colin.goldin@credit-suisse.com Marwan Abboud +44 20 7888 0082 marwan.abboud@credit-suisse.com Liesbeth Baudewyn +44 20 7888 7988 liesbeth.baudewyn@credit-suisse.com Disclaimer: Please follow the attached hyperlink to an important disclosure: http://www.creditsuisse.com/legal_terms/market_commentary_disclaimer.shtml. Structured securities, derivatives and options are complex instruments that are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation for any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation. Use the following links to read the Options Clearing Corporation s disclosure document: http://www.cboe.com/learncenter/pdf/characteristicsandrisks.pdf Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. This material has been prepared by individual traders or sales personnel of Credit Asia Suisse Securities Limited and not by the Credit Suisse research department. It is Karan Karia +852 2101 6322 karan.karia@credit-suisse.com provided for informational purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. It is intended only to provide observations and views of individual traders or sales personnel, which may be different from, or inconsistent with, the observations and views of Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions of Credit Suisse. Observations and views expressed herein may be changed by the trader or sales personnel at any time without notice. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. The information set forth above has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, but each of the trader or sales personnel and Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or changes in market factors. This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view of a particular market. Credit Suisse may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. The most recent Credit Suisse research on any company mentioned is at http://creditsuisse.com/researchandanalytics/ 2013, CREDIT SUISSE 6