ETF managers could reduce FX hedging risk through this execution model

Dan Barnes Welcome to ETF TV, I’m Dan Barnes. FX hedging is important to all investment managers and increasingly so for passive fund managers. Today we’re talking with Jay Moore, founder and CEO of FX HedgePool.

Deborah Fuhr I’m Deborah Fuhr from ETF TV. We’ve seen a significant increase in the use of currency hedged ETFs, and hedging of underlying portfolios. Welcome, Jay.

Jay Moore Thank you, Deborah and Dan for having me here today. Looking forward to the discussion.

Deborah Fuhr Jay, what was the genesis of FX HedgePool and P2P matching in the FX swaps space?

Jay Moore There’s been a major shift in what the buy-side thinks about when they consider their overlay programs, their passive hedging programs. And one theme that repeatedly has come up is this idea of P2P, who have naturally offsetting requirements.

Dan Barnes How does it benefit traders and portfolio managers, specifically?

Jay Moore If you think about a hedged ETF, right. What are they tracking? If it’s an international bond fund, that index that’s published that it’s tracking every month is basically made up of the underlying holdings of the index, calculated using a certain methodology. And then if it’s a hedged portfolio, it’ll also include the overlay performance of a synthetic basket at a very prescribed sort of methodology. And then you combine the two. So the portfolio managers and the traders are very, very keenly focused on how do they mimic the performance of that overlay portfolio as precisely as they can. And you have this conflicting challenge in that the benchmark is so known, and the larger the funds are, the more volume you’re doing in the market, the more time you need to execute those trades. So large ETF managers are trying to meet a very specific point in time, but because of the volumes, then they need to avoid market impact and get fair pricing. They may be trading days and sometimes weeks in advance of their benchmark in order to get that volume through the market. And so what they’re doing in many cases is trying to save, you know, five dollars a million in spread by getting a good price a week ahead of the benchmark, but potentially introducing 50 dollars in slippage or risk from their benchmark.

You know, traders are thinking about things like, ‘how do I get my trade done at the best price possible at a given point in time without negatively impacting the market?’ Whereas portfolio managers think a lot more about things like performance. Specifically in the ETF and index tracking space, you know, a benchmark is a very relevant part of their performance metric. And so where P2P is helpful, to meet both of these objectives is by avoiding the need to go to the market, so the open market. You eliminate altogether this idea of market impact or footprint, because there’s nobody sort of managing risk against you. So the traders can, from their perspective, eliminate the market impact, but they also can do it at a price that’s predetermined, right, because things like volatility in the market and supply and demand, the supply and the demand are both known in advance. So pricing and spreads become less of an issue and they can be determined up front to cover costs relevant to the trading and the booking in the settlement of that trade. What we built at HedgePool is really particularly interesting, I think, for ETFs and index trackers. Where that tracking error, that benchmark is so highly relevant.

Deborah Fuhr When you think about ETFs and index funds, do you find that there’s more users of your service in Europe than in the US?

Jay Moore I wouldn’t say there really is much of a difference regionally. You know, as you mentioned, the growth in the FX hedging space is in part due to the ETFs’ growth and the index tracking, but also the asset manager community is becoming more global in nature and therefore are distributing their funds. A US manager who’s had a lot of success with the strategy in the US might say, ‘well, why can’t I distribute that similar strategy to investors throughout the world?’ You know, global distribution is on the forefront of every asset manager now in their growth strategies for the next 10 years.

Dan Barnes Do you think the increase in fixed income ETFs is likely to see an increase in demand for FX hedging?

Jay Moore Absolutely, yeah. I think fixed income managers have so much more sensitivity to FX, and so in many cases, you’ve seen fixed income portfolio managers are also kind of FX portfolio managers, or fixed income traders, are also FX traders, because they have to do these things kind of in sync and they’ve always been tied together. Whereas again, with equities, it’s just kind of it’s a 50-50, flip the coin, and sometimes it’ll hurt you, but it’ll wash out in the end. I don’t think fixed income managers have that luxury. So with that in mind, just the growth in fixed income and the forever focused view on FX; it’s just going to continue and therefore the volumes will continue to grow with the size of the funds.

Dan Barnes What are the efficiency pressures that you think passive managers are under? Which might see the adoption of P2P trading for FX?

Jay Moore You know, these managers are really competing on fees and performance, right? So becoming more efficient, not only with the trading process itself or the electronification of trading, but also with the resources that these firms deploy to getting these trades done. I mean, as the firms grow, as the assets under management grow, they can’t continue scaling up their resources, the people, to get these things done. So they need more efficiency and cost to do so. For those reasons, I think you’re going to see a continuation of interest in electronification, automation. And again, when you don’t have to go out and negotiate month after month with a panel of banks for your FX swaps, which probably make up +95% of your FX volume in an index fund, and that can be automated, I think that’s a pretty big win in terms of the efficiencies.

Dan Barnes Jay, thank you very much.

Jay Moore Thank you. Pleasure to be here.

Dan Barnes I would like to thank Jay and Deborah for their insights and an interesting discussion today, and of course you for watching. To catch up on our other shows or to subscribe to our newsletter, go to ETFTV.NET and TRADERTV.NET.

Published on October 15, 2020