CP+™ for ETFs: Improving ETF portfolio management with predictive pricing

Kat Sweeney, Global Head of ETFs and Data Solutions at MarketAxess, sat down with Jeff Lenamon, Head of Portfolio Construction & Senior Portfolio Manager at DWS, to discuss how DWS has improved the performance of their ETFs by integrating CP+ into daily workflows and the create/redeem process. Starting his career in Fixed Income in 1998, Jeff is an industry veteran who has managed Credit ETFs since the 2000’s, including HYG and LQD during the financial crisis.

Kat Sweeney:

Much has been written about the growth and trading of Fixed Income ETFs, but there is little known about the complexities of actually managing an ETF. I joke, (but it’s true!) that you are one of the “OGs” of the ETF world—so can you set the scene for us?

Jeff Lenamon:

“Industry veteran” and “OG” makes me sound older than I am. But I was fortunate to be introduced to the asset class in the early stages.

Anyway, to your question: To create Fixed Income ETF shares, the ETF Portfolio Managers (PMs) work with Authorized Participants (APs) who provide liquidity in ETF shares to clients. Since most portfolios hold upwards of thousands of bonds, the PMs negotiate optimized creation units called Custom In-Kind Baskets (CIBs) to facilitate the process. This negotiation is an active process between the ETF PM and the AP. While trading of an ETF happens throughout the day at varying prices, a creation is priced at the Net Asset Value (NAV) which is determined by valuing the portfolio at an End of Day Evaluated Price.  

While the CIB creation process offers many benefits, there are specific challenges an ETF PM faces, largely due to how the fund synthetically buys or sells underlying securities at the Evaluated Price. PMs must evaluate the impact that each CIB will have on the fund, to ensure he or she is not introducing tracking error.

Kat:

Let’s dig into that a little more. We know that fund managers try to minimize tracking vs. the benchmark, focusing on the “market factor.” What other factors can influence the performance of the fund?

Jeff:

Yes, that’s right. As you say, fund managers have traditionally focused on trying to minimize tracking vs. their benchmark across issuer, sector, ratings, maturity, and capital structure. However, pricing skew can also play a contributing factor into tracking error and ultimate fund performance.

As you know, unlike Equity ETFs, where the NAV is determined by the official closing price of each stock, Fixed Income ETF NAVs are determined by “Evaluated Prices” that are offered by multiple vendors. The complexities of our market and the illiquidity of some bonds can lead to distortions—pricing skew—between the Evaluated Price and where the market is actually trading. Fund managers will routinely “challenge” Evaluated Prices they believe are off market, but this process typically happens only after the prices are published, meaning they don’t pick up the skew intra-day.

When I moved into the PM role, we focused on the difficult and complex task of managing the CIB process and monthly rebalances. We realized that the traditional approach to evaluating pricing skew could be addressed effectively by leveraging some of the liquidity and pricing products we used in my prior trading role. This was important—because having confidence in the end-of-day price and being able to adequately gauge bid-ask spread and liquidity estimates of bonds, is fundamental to the successful management of our funds.

Kat:

…and so enters MarketAxess CP+…

Jeff:

Yes. We introduced CP+ predictive pricing across our portfolio management, optimization, and trading processes, developing a streamlined “skew assessment” that assesses the discrepancies between the funds’ expected end-of-day prices vs. CP+ throughout the day.

This approach helps the team identify outlier bonds, reducing the potential to deliver a “cheap” bond via a creation or a “rich” bond via a redemption. At the fund level, we can use CP+ to determine intraday moves and realistic market execution levels, which provides greater transparency into skew estimates, so our talented PM team potentially reduces tracking errors and ensures NAVs are being marked efficiently.

Kat:

It’s the perfect example of how the ETF ecosystem is driving innovation in both market mechanics and the data solutions that support them. Innovation that wouldn’t happen without the support and collaboration between you, DWS and MarketAxess, so I do want to say a big thank you to you and your team for your partnership.

If you don’t mind, I will conclude briefly:

This includes, but is not limited to, better and more accurate evaluated pricing models; real-time predictive pricing; and access to deeper and broader credit liquidity pools. Those who do it successfully, as Jeff has described, will see immediate competitive value for their funds, and will be able to measure, automate and execute against their desired portfolio strategies with confidence.

About CP+ and our Evaluated Pricing partnership with S&P Global:

CP+ is the MarketAxess award-winning, algorithmic pricing engine which provides nowcast prices, calibrated to reflect trades as closely as possible without introducing bias.

Last year, MarketAxess and S&P Global announced a historic pricing partnership where CP+ is ingested into their Evaluated Bond Price (EVB). This partnership bridges the gap between CP+'s predictive price, used for intraday trading decisions, and the Evaluated Price, used to value FI ETF NAVs. To find out more, click here.

MarketAxess would like to thank Jeff Lenamon and the entire DWS team for their continued support and consultation, so that we can continue to provide best-in-class data solutions for our clients.

Opinions expressed herein may differ from the opinions expressed by departments or other divisions or affiliates of DWS. All investments involve risks, including potential loss of principal. DWS and MarketAxess are not affiliated. The brand DWS represents DWS Group GmbH & Co. KGaA and any of its subsidiaries, such as DWS Distributors, Inc., which offers investment products, or DWS Investment Management Americas Inc. and RREEF America L.L.C., which offer advisory services.

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