The price of FX hedging is increasing once again, potentially causing currency challenges for fund managers. In this article, Eric Huttman, CEO of MillTechFX, addresses the issue of rising hedging costs, explaining why FX hedging is so important for fund managers and how they can reduce their hedging expenses.
Fund managers employ FX hedging strategies for a variety of reasons. For example, they need to mitigate the volatility and risk associated with currency fluctuations for their portfolios and investors, and even related to their own fees.
FX hedging costs are on the rise again, continuing the pattern seen in previous years and reaching highs not seen since the beginning of the year.
Recent research shows European fund managers are feeling the pinch, with 84 per cent stating that their hedging costs had increased over the past year. Rising FX hedging costs can affect them in numerous areas, including portfolio returns, investor commitments and fee income.
But why is the price of FX hedging rising? And how can fund managers navigate rising costs in an area that is so vital to their businesses?
Behind the rise in hedging costs
Global FX hedging costs have increased in step with geopolitical tension and economic troubles, as many large economies fight to keep inflation at bay. Such issues create an unpredictable environment for investors and businesses, making them unsure about future activity and leading to more sporadic fluctuations in the currency markets. What’s more, as global uncertainty and inflation remain high, so does fixed-income volatility, further contributing to the increased cost of currency hedging.
In addition, market volatility can bring reduced liquidity as liquidity providers widen their spreads to shield themselves from unpredictable currency movements. In addition, some providers may withdraw from the market during times of geopolitical and economic uncertainty. This reduces the number of liquidity providers active in the market, further increasing the cost of hedging currency risk.
An essential tool for fund managers
Global FX volatility makes currency hedging even more crucial for fund managers. As the risk of unpredictable currency movements increases, so too does the need to protect portfolios from them. In this sense, hedging more during times of higher volatility enables fund managers to add a layer of certainty, stabilise returns and focus more on the performance of their investments, rather than on currency fluctuations.
One of the drawbacks of hedging is margin (I.E. collateral), which can act as a hidden hedging cost and put fund managers off hedging their FX risk.
Any capital posted as collateral is effectively sitting dormant in a margin account and not available as working capital. The FX risk, mitigated with forward contracts, has been replaced with a potential liquidity risk. This is an implicit cost that fund managers must also consider.
One way around this issue is to trade via an uncollateralised FX facility so that a fund manager can hedge using forwards and not worry about posting margin. Some solutions crucially offer this service without jeopardising best execution, ensuring total cost transparency.
Keeping costs at bay
The first step that firms can take towards saving on their FX hedging costs is Transaction Cost Analysis (TCA). To effectively manage and hedge FX exposures, it’s important to first measure the cost and quality of your execution and to get a view of all costs.
TCA was specifically created to highlight hidden costs and enables firms to understand how much they are being charged for the execution of their FX transactions. It goes hand in hand with best execution, serving as an ongoing audit of FX practices. Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.
Fund managers should also look to compare the market. By securing multiple quotes from a variety of FX liquidity providers, fund managers can compare pricing on hedging instruments, such as FX forwards, enabling them to find the most competitive rates. Technology platforms can also help here, centralising FX data from a range of counterparties and service providers to make best execution easier to find.
The significance of proactive FX management cannot be overstated. Fund managers must prioritise regular monitoring and strategic adjustments to their FX strategies to safeguard their returns and operational stability.
As we navigate through dynamic market conditions and pivotal political events, a diligent and forward-thinking approach to FX hedging will be crucial for avoiding pain, protecting returns and achieving sustainable success.
