Whether through Dublin and Luxembourg UCITS, or Cayman funds sold into Japan, investment managers looking to expand their global footprint have been using currency-hedged share classes as a key component of their cross-border distribution strategies for years. Today, currency-hedged share classes have become standard practice for globally-minded firms launching new products.
Asset managers use share classes to deliver a common investment strategy to a broad range of investors. Class types include retail versus institutional, income reinvesting versus distributing, varying fee structures, and share classes denominated in foreign currencies. It’s the final category that presents a unique risk that the other class types do not: Foreign Exchange (FX) risk. Investing in an unhedged class of a fund that is denominated in a currency other than the base currency of the investment strategy exposes the investor to cross-border translation risk, resulting in potentially significant return differences.
Take, for example, an investor in London considering the purchase of an unhedged GBP share class of a UCITS fund managed by a US manager in USD. The historical investment performance was realized and published in dollar terms, yet the UK investor’s returns will reflect both the USD-based strategy performance and the GBP/USD translation to the share class. If investors fear USD weakening or, more likely, have no expectation of currency performance at all, they may prefer to avoid the unknown risk and search for a similar investment strategy closer to home.
Alternatively, if the US manager offers a hedged GBP share class, the UK investor could access the intended investment performance without the unwanted FX risk. Simply put, the hedged share class is designed to mitigate the FX risk by including FX forward contracts to “hedge,” or offset, the FX translation risk of the class relative to the base. The net result is:
The effectiveness of the hedge will depend on how accurately and consistently the gains or losses from the FX Forwards will offset the Currency Translation Effect. The hedged return should yield relative performance in line with the base strategy, subject to the effect of implementation, market, or accounting related factors.
The consistency of relative performance is measured as “tracking error,” which is defined as the uncertainty, or standard deviation, of return differences between the fund in base currency terms and the currency-hedged share class. The lower the tracking error, the more closely share class performance aligns with the underlying fund strategy.
Defining a hedging program to produce optimal performance can be complex and varies according to the characteristics of the investment strategy and share class currency. Several implementation and accounting-related factors influence share class performance, including rebalance frequency, hedge ratio filters, treatment of investor flows, and class specific accruals and fees. A properly calibrated program can yield ideal performance; however, poorly defined programs can produce suboptimal returns and damage investor confidence.
Beyond the operational parameters of a hedging program, the two primary drivers of the performance of a well-calibrated and operationally sound program are typically interest rate differential and execution slippage.
Interest Rate Differentials
Forward FX contracts must account for the difference in local risk-free interest rates between the two currencies traded – known as the interest rate differential. In an efficient market, investors cannot borrow in a low interest rate country (based on local risk-free rates), convert their cash to another currency where they can then invest at higher local risk-free rates, and hedge the FX risk to net a risk-free return. Therefore, forward FX rates must include “forward points” that account for this interest rate differential. This represents an economic certainty built into the performance of FX-hedged products. While interest rate differentials are an inherent component of hedge performance, there are several other considerations that should impact the selection of FX Forward tenor.
With fluid regulatory demands, newly defined reporting requirements, and investor scrutiny around transparency, asset managers are focusing on the trade execution process related to share class hedging programs more than ever. Poor execution quality can be a drag on performance, and inconsistent execution timing can create tracking error.
The managers’ ability to demonstrate an execution process that aligns with both the hedging objectives and their definition of best execution is essential. This may include limiting tracking error by aligning investor flows with the fund’s valuation rates and avoiding unnecessary execution latency while minimizing cost through netting and competitive dealing with multiple banks.
A particular challenge in evaluating execution quality is the complexity of measuring costs in the FX forward markets. Forwards are highly customized, bilateral over-the-counter (OTC) trades with little in the way of standardized benchmark data. While Transaction Cost Analytics (TCA) for FX forwards is improving, demonstrating a well-designed execution process with sound oversight remains a top priority.
DIY or Hire a Professional?
Due to the complexities of implementing, maintaining, and demonstrating an effective hedging program, managers should ask themselves:
- Do we approach hedging as a core competency or treat it as an operational burden that introduces uncompensated risks?
- Are we equipped to provide our internal and external clients with the level of transparency and detail required to validate the effectiveness of our hedging program in a world of increased scrutiny on cost and performance?
- Do we have the scale to grow and the tools to evolve our process as the market changes?
After careful consideration, many managers agree that they are better served to direct their valuable resources to strategy performance, their true differentiator. Even for those managers who have successfully implemented an in-house hedging program, many are reevaluating their ability to adapt to regulatory changes or meet the demanding requirements to demonstrate oversight and control in a transparent manner.
Some managers solve for this by delegating to a service provider, while maintaining control and oversight. Managers must ensure that their hedging providers not only meet operational requirements, but also provide robust oversight tools, detailed performance insights, and transparent execution reporting on an easily accessible platform. This will give managers all the tools they need to handle the ongoing discussions with investors, regulators, and fund boards around appropriate investor performance and cost.
A comprehensive understanding of the broad array of factors that influence performance of share class hedging programs can be the difference between a well-oiled machine and a disaster waiting to happen. The ability to measure and validate results is essential to improving the process, gaining the trust of end investors, and satisfying regulatory demands. These considerations can be the edge in setting investment products apart in a market where competition is fierce and standards are rising. A well-implemented program can tear down cross-border distribution barriers and arm sales teams with an arsenal of highly effective and transparent investment choices for potential investors across the world.
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