As any portfolio manager will attest to, getting a handle on how expensive it has been to trade the pound has been about trying to find out whether a 10bps cost saving on expected costs has been achieved or not. But as sterling continues its rally against the dollar, portfolio managers now have numerous different trading styles to choose from in comparison to a decade ago – with FX trading more complicated than ever.
As a result of the different trading styles, it is not a case of one size fits all when it comes to trying to work out what the costs of trading sterling actually are. There are now different cost models with numerous different metrics. Therefore, if a portfolio manager is still adopting old methods of looking at longer-term trading strategies, they will be looking at the trade based on the size of the trade, as opposed to how long they decide to trade the currency for. This could be problematic when trying to execute a long position, where an investor expects the underlying asset to appreciate. Some analysts, including the likes of Nomura, NatWest Markets and HSBC, all see the pound reaching 1.30 against the dollar in the months ahead. Given the fact markets expect at least another 0.5% hike from the Bank of England this year, compared to at most a 0.25% increase by the US Fed, investors may be expecting sterling to continue appreciating against the dollar across the rest of this year, and even into 2024.
Given the macro situation, a portfolio manager at a hedge fund may be expecting the pound to appreciate against the dollar over a longer time horizon. It could well be that their position in sterling is a sizeable one. But it should not be because a trade is an expected size that the cost will always be a certain amount. When executing larger orders over multiple days, there is a need to know exactly what the benchmark for a trade of this nature is. One static benchmark in time is not going to cut the mustard when trading over the course of a day, pausing, and then resuming trading the pound over multiple days. The underlying market could have moved significantly by the time the portfolio manager picks up their position in sterling.
All this means that, ultimately, there is a genuine need to work out execution costs not only by calculating the total average executed cost incurred versus the arrival price, but by instead drilling down into the different cost components. This means getting a grasp of exactly what the costs are made up of. Typically, a portfolio manager will have an overall cost comprising the GBP/USD trade, alongside the rate of arrival or risk transfer price. The challenge is that more often than not, someone may well execute this trade without really understanding exactly where the cost is coming from.
For instance, there could well be slippage when trying to get an order filled, and the rate of the bid/offer spread at the time of the fill. This means the portfolio manager would need to try and work out what was happening in the wider market during the time they were executing the order.
Understanding where costs are emanating from is particularly important in over the counter (OTC) dominated markets, like FX. For instance, measuring what is happening in the short five to ten second window prior to executing with a particular bank. As a case in point, if a portfolio manager executes over 1,000 different orders over six months with one investment bank, and then another 1,000 with another, there is a need to work out which bank is causing the market to move.
A buyer of sterling may be executing with one of the banks. However, what happens if every time the buyer executes, the market jumps 20 dollars per million on average? In this case, the portfolio manager knows that when entering the market again that 30 seconds out, they are going to be 20 dollars per million worse off. In this situation, it all comes down to trying to isolate the impact being caused across market versus how the market is performing in general. This is particularly important for positions being left overnight that are being affected by underlying market movements, as opposed to the trading strategy of the portfolio manager.
For far too long now, investment managers have been in the dark as to exactly where the costs have originated from. Portfolio managers trying to address a longer-term trading outlook for sterling by referencing one single static point in time is simply not fit for purpose. Sure, one can still rely on more traditional methods, such as the time-weighted average price (TWAP), for looking at trading over a longer time period. But the reality is that existing methods give a somewhat distorted view, as they include long periods where someone was not actively trading in the market. If analysts are correct and the pound continues its rally against the dollar for the remainder of 2023, then now is the time for portfolio managers to isolate their execution costs from those driven by market movements.
Daniel Chambers is Head of Data and Analytics at BidFX (an SGX company)
