Hedged share classes seek to minimise a fund investor’s currency risk. Specifically, they aim to reduce the impact of exchange rate fluctuations between the fund’s base currency and the investor’s preferred currency of exposure.
Hedged share classes can be a useful tool for mutual fund — also known as unit trust — investors to gain exposure to assets denominated in foreign currencies, without taking on the full accompanying currency risk.
Where available, they can allow investors to effectively make independent decisions on which assets they want exposure to, and which currencies they want exposure to.
While hedged share classes can be a powerful part of an investor’s toolkit, they are designed to minimise, but not completely eliminate, the risk of currency fluctuations.
What are hedged share classes?
Hedged share classes seek to minimise, but cannot completely eliminate, a fund investor’s currency risk.
Specifically, they aim to reduce the impact of exchange rate fluctuations between the fund’s base currency and the investor’s preferred currency of exposure.
At a high level, a fund investor’s returns can be broken out into the below components (see Figure 1 below). The goal of a hedged share class is to minimise the final part of that equation.
Figure 1: Investor’s returns breakdown
For example, a UK-based investor seeking to gain exposure to the US bond market, but wanting to minimise exposure to exchange rate fluctuations between the US dollar (USD) and the British pound (GBP), could purchase the GBP-hedged share class of a US bond fund.
A variety of hedging approaches, including multi-currency hedging and partial hedging, can be used to pursue a variety of different goals, but this note will focus on the most common form of hedged share classes.
What are some reasons investors use hedged share classes?
- Minimise unwanted exposure to a foreign currency: Investors often seek to gain exposure to assets outside their local markets for the diversification benefits, but do not wish to expose themselves to additional currency risk that these assets may bring.
- Reduce complexity: Administering a currency hedging programme can be complex, and is something many investors would prefer not to do themselves.
- Convenience: Hedge share classes may allow investors to purchase fund shares in their preferred currencies instead of having to pay for shares in the fund’s base currency.
How do hedged share classes work?
- An investor purchases shares of a hedged share class in the hedging currency
- The fund manager receives the investor’s funds, and as soon as possible will engage in two currency transactions:
- Converts the investor’s funds from the hedging currency into the fund’s base currency, which can be used to purchase assets for the fund. This is done at the spot foreign exchange rate.
- Hedges the investor’s currency exposure. This is most commonly done through a currency forward, which allows the fund manager to convert an agreed-upon amount of the fund’s base currency to the hedging currency, at a set price at a set date in the future. This set price is the forward foreign exchange rate. Importantly, only the value of the hedged share class is hedged, which means there will be no impact on the returns of the broader fund.
- The fund manager will renew or “roll-over” the currency hedge on at least a monthly basis, updating it to reflect the current value of the underlying assets. The fund manager, however, may roll-over the hedge on a more frequent basis in periods of market volatility and when required by regulation.
- When the investor wishes to redeem their shares in the fund, the fund manager will convert the fund’s base currency into the hedged currency, which will be distributed to the investor. The fund manager will also adjust the hedging level of the hedged share class.
Figure 2: Differences in returns between a funds’ hedged share classes and unhedged share classes
What causes differences in returns between a funds’ hedged share classes and unhedged share classes?
- Interest rate differential: This can have a positive or negative impact on hedged share class returns. A hedged share class may have higher returns than the unhedged share class if the hedging currency’s interest rate is higher than the base currency’s interest rate. Conversely, a hedged share class may have lower returns than the unhedged share class if the hedging currency’s interest rate is lower than the base currency’s interest rate.
This is because the pricing of the currency forwards used for hedging takes into account the different interest rates that investors would earn holding different currencies.
These relationships are governed by an economic concept known as interest rate parity (see illustrative example box below), which broadly holds in most market environments.
- Cross currency basis: Like in any other market, the price of currency hedging contracts will be influenced by supply and demand. This is known as cross-currency basis, and can make hedging more or less expensive depending on market conditions.
- Unrealised profit and loss from the currency hedging contract: The value of the currency forward contract may rise or fall in value, but these gains or losses will remain unrealised until the contract is closed and cash is transferred.
In the interim, unrealised gains or losses will be reflected in the value of the hedged share class, but will not actually be able to be reinvested by the fund manager, which could result in marginal dilution of both positive and negative performance compared to the unhedged share class.
- Transaction costs: There are small transaction costs from hedging that will only detract from the performance of the hedged share class. Transaction costs will likely be higher in periods of market volatility.
- Intraday currency volatility: Given the constantly moving nature of markets, it is impossible to perfectly currency hedge a share class. A hedged share class may have currency exposure for a short amount of time between when hedged share class shares were purchased and when the fund manager is able to enter into a hedging contract.
Do hedged share classes have an impact on other investors in the fund?
All gains, losses, and transaction costs of hedging transactions are solely borne by the investors in the hedged share class.
Counterparties of the hedged share class’ hedging transactions may have recourse to the assets of other share classes, but this would likely only be relevant in an extreme market scenario.
Hedged share classes may provide some benefit to other investors, by allowing the fund’s investor base to be larger and more diverse, which may help mitigate disruption from concentrated fund redemption and purchase activity.
This article was originally published by PIMCO.
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