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Factor investing – liquidity is everything (part II)

Release date: 07 Sep 2018 | Eurex Exchange, Eurex Clearing

Factor investing – liquidity is everything (part II)

Part II of our factor investing article series deals with the iSTOXX® Europe Factor Index Futures. In an interview, Zubin Ramdarshan, Eurex' Head of Equity & Index Product Design, talks, among others, about the importance of liquidity, the motivation of market participants and the impact of macroeconomic metrics on factor combinations.

Randolf Roth, Member of Eurex Frankfurt Executive Board, responsible for market designZoom

Zubin Ramdarshan, Head of Equity & Index Product
Design, Eurex


A key issue is always liquidity, how does Eurex ensure that, once listed, the product has enough liquidity?

Demand is usually the first driver. So do we have enough end customers or members who want to have access to factors? The answer is yes. The second question is who will supply liquidity? This is where we turn to our liquidity providers. We approach members who are already quoting related products. We assist them to understand the index calculation methodology and to acquire the necessary data on index constituents and weightings. Then we normally structure an incentive scheme for liquidity providers and set the associated obligations on quote size, spread and coverage during the trading day.

And how is the response in terms of Factor Index Futures?

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Read our factsheet on iSTOXX® Europe Factor Futures and find out more about contract specifications, Market Makers, Eurex Clearing Prisma and much more.

 
There is definitely a strong demand, especially from the buy side. On the supply side, we have two to three on-screen liquidity providers who are already active. We require them to quote a minimum of 80 contracts and a spread of 80 basis points. But, if we take a look at the order book, the actual liquidity is much deeper. We have seen quotes for more than 550 contracts and narrower spreads of 0.3 to 0.5 index points. In addition, there are further liquidity providers in the pipeline.

Who is using the contracts and what are their main motivations?

The main drivers behind the volumes are asset managers - long only or long short asset managers. The reason is that there is a large body of academic research based on empirical evidence that shows that factors can be a source of additional return or risk premia. Prior to the iSTOXX® Factor Futures launch, an asset manager typically would have constructed a customised basket e.g. the value STOXX or momentum STOXX may have traded in an OTC swap format. With regulations generally migrating OTC business towards listed products on Eurex, our futures offer the combination of a centrally cleared instrument traded transparently via the order book.

Another driver has actually come from the ETF world, with ETF Market Makers especially hedging their exposure with listed futures. The reason here are margin efficiencies from using futures and order book liquidity, in comparison to trading the full creation unit of an underlying ETF.

Which strategies are being mainly employed?

There are two main strategies employed: one is simply long-only, so buying iSTOXX® Factor Futures on Eurex and rolling quarterly to allocate a portion of AmU (Assets under Management). This would be part of a broader portfolio with desired factor tilts. The other strategy is long-short. This enables market participants to really isolate the factor by opening a long positon in iSTOXX® Factor Futures and simultaneously opening a short position in STOXX® Europe 600 Futures. And the reason why you would wish to do this – again there is a body of academic research e.g. supplied by Alpha Centauri with whom we are partnering in the iSTOXX® risk factor segment. It shows that upon isolating some of the factors, there is either very low correlation or in some cases slightly negative correlation with traditional equity markets. For many asset managers, accessing uncorrelated returns is a major focus.

What about cyclicality? Do certain factors have increased demand in view of the current economic development?

There is some evidence that points to a link between which factors tend to perform better under certain macroeconomic conditions; for example links to the interest rate cycle or equity valuation metrics. The other way they vary is actually by region. Thus, certain factors that may perform very well in let say US or European developed markets can have very different behaviour for Asian emerging markets.

In addition, there is a great deal of research that analyzes the performance of combinations of factors. For example, in a certain economic cycle the iSTOXX® Europe Value Factor Index and the iSTOXX® Europe Momentum Factor Index may be in demand, which is what we currently observe looking at open interest. However, that can change again, especially if we experience a factor rotation within broad equity markets.

What are you planning for the future?

We want to see a solid liquidity pool established, then we may push forwards. Typically, at the beginning of a product cycle we see relatively more block executions and this means a portion of volume is traded outside the order book. Subsequently, as a product develops and is adopted by more participants, we would anticipate more trading volumes directly in the order book. With regard to our Factor Futures, we expect to remain in the growth phase through to the end of 2019.