Deborah Fuhr Welcome to ETF TV, I’m Deborah Fuhr. This year, we saw that the Fed buying high yield and investment grade ETFs really raised the awareness and confidence in those products. And year to date, we have seen 64 billion of net new money going into investment grade ETFs. High yield ETFs have taken in 10 billion.
Dan Barnes And I’m Dan Barnes. We’re now going to talk about the use of ETF options by bond investors for hedging and risk management for their portfolios. Joining us are Robin Fox, credit volatility trader at J.P. Morgan, and Lee Bartholemew, head of derivatives products R&D for fixed income at Eurex. Guys, welcome to the show.
Robin Fox Thanks for having me.
Lee Bartholomew Thanks very much for having us.
Dan Barnes Robin, if I can start with you; for which instruments are investors using options to hedge their risks?
Robin Fox The biggest growth in that space is probably the credit ETF options market. It’s not really been a, or at least in Europe, it’s not really being a market that’s been extremely developed. But with a pretty big growth in actual underlying ETF trading volumes as well, we start to see investors kind of ask for new ways that they can hedge their credit portfolios.
Deborah Fuhr Why do you think investors are using fixed income ETFs?
Robin Fox 2020 is kind of a perfect example for why people have been using them. It’s been a year with incredible volatility. We’ve seen the extremes on both ends. You know, we are at all time highs in pretty much every asset I can think of. And we’ve seen some of the lowest or widest levels in credit spreads that we’ve seen in the last 10 years pretty much.
Dan Barnes Using credit default swaps, credit default swap options, equity options, what are the pros and cons of each of those to try and hedge the risks that investors are facing?
Robin Fox I mean, I guess the immediate pros and the reason that most investors have been using alternate startups as a port of first call in the last few years and reuse the liquidity. The debt of that market is obviously pretty much unparalleled in credit, especially sort of in the options market, on the hedging front; the volumes that you can do there are pretty significant. Clearly, some investors also turn to the equity options market again, purely from a sort of depth perspective. And occasionally, because they think it’s cheaper to hedge with equity options. Clearly, the pros and cons of that, as we’ve actually seen in 2020, is, both markets don’t necessarily always track like for like. So whilst they’ll probably go generically in the same direction, the magnitude of the moves can be quite different. ETF options or linear ETFs as well as kind of a better alternative for that.
Lee Bartholomew I think liquidity comes out in what Robin is saying, and I think if you look at ETF options, it’s another tool which is additive to the tool kit of the end investor. When you’re looking at ETFs with the spread volatility, just with the basis tracking and arrow tracking, they want the hedge, which covers more of their bases. And I think on the fixed income ETF-option side in Europe, it’s taking longer to gain traction, but when you see investors get comfortable, the risk that they’re willing to then put on is quite significant. So you can see up to a billion of the underlying initiated in one single trade and the market makers are comfortable taking down that risk themselves. And therefore, I think that gives the end investors comfort that, that’s a product that you can use.
Deborah Fuhr Are there any restrictions when investors are running UCITS funds using these instruments?
Robin Fox The one that’s most obvious is IHYU. A lot of clients effectively want to take exposure on dollar high yield ETF, which is HYG, but it’s not actually UCITS-legible, so clearly they run into a bit of a speed bump there. The London-listed IHYU is almost identical in terms of underlying portfolio, but it’s UCITS-legible. There are even some funds which have mostly non-UCITS, but then have some pockets which are UCITS, and they’ll do a large part in HYGeach leg and then some of it in IHYU, just to satisfy that, and make sure that they can have the same level of protection or same level portfolio exposure across all of their funds.
Dan Barnes What’s the level of engagement you see in the options markets today?
Robin Fox The US high yield market is enormous, you know, five to 10 years ahead of the European market. So it kind of sets the stage for what might be the potential in the coming years. The next level down from that is probably the UCITS versions of the US underlying, like we just mentioned, so IHYU, but that’s sort of more sporadic. But, you know, you do occasionally still see some relatively large trades. And on the third level and the one we’ve been focusing the most on this year is the European credit ETFs, so European high yield and European IG. Those saw quite a lot of engagement in Jan-Feb, the pandemic then kind of struck just as things were getting going. I think that naturally put off a few investors. The market is still kind of getting back to grips with what normality looks like in terms of trading, especially in the credit world. And so in the coming 12 months, I’d imagine that we’re going to see a pick up in that again and see more and more interest.
Deborah Fuhr What type of investors do you see using these products and is it more tactical or strategic in the way they’re using them?
Robin Fox We see literally every kind of investor, all sorts of trades. So you see the really, really big, strategic trades. It could be a fund that’s had a very, very good performance year to date, and they want to kind of lock in the gains that they’ve had without completely unwinding their risk. You might also see someone hedging a very large risk event, so we just had the US election. The market looks oversold here, but I’m not of super high conviction, and I don’t really know if I want to add a lot of risk. That’s been a very topical one in 2020, because at some points the market felt like the bottom was dropping out. So turning to auctions and buying calls or receiver options, that was extremely popular.
Dan Barnes Lee, are there any other points you have there in terms of level of engagement, and the way you are seeing instruments used?
Lee Bartholomew As an exchange, what we are trying to work with people on is the education around the use cases, but then also focusing on, ‘how do we ensure that you get a little bit more frequency in the volumes,’ to complement the bigger trades when they come in. So there’s less kind of gap between risk being put on and put off. And I think 2021 will be a good platform for which to kind of then really pick up in scale.
Robin Fox I would say is very rare where you have one extremely large, developed product in one region, namely the US, that doesn’t end up following suit in Europe. It’s only a matter of time until the European credit ETF option market does pick up. Borrow on the underlying, it’s one of the biggest differences between the US and Europe. In the US, every holder of the ETF tends to want to lend out the shares that they have. In Europe, that’s still a bit of an issue, but it’s being worked on and it’s already improving a lot. So I think that’s one of the key things that is slowly starting to unlock liquidity in this sort of hedging repo and options market.
Dan Barnes Lee, Robin, thank you.
Robin Fox Thanks very much.
Lee Bartholomew Been a pleasure.
Dan Barnes I’d like to thank Robin, Lee and Deborah for their insights today, and of course you for watching. To catch up on our other shows or to subscribe to our newsletter, go to ETFTV.NET or TRADERTV.NET.