In this article, we are going to explain what a Hedged Share Class is and we are going to run some numbers in order to better understand how they work and the divergences that can result when comparing them to their Reference Classes.
Let’s take a USD investment fund as an example. This will be our Reference Class. Then, an analogous GBP-denominated Share Class is created, accessible to UK investors. This new class is a fund with currency risk, whose performance is similar to the original USD fund, but with the addition of the GBPUSD spot risk.
To avoid the spot risk, a Hedged Share Class is provided, whose management, in addition to investing in the USD fund, includes hedging the GBPUSD risk. Hence, this Hedged Share Class will obtain the performance of the USD fund combined with the result produced by the hedging. This hedging will cancel the GBPUSD movement. As a result, the tracking error relative to the reference fund, the USD fund, will be better than in the previous case of the Unhedged Class.
Investors often seek exposure to assets outside their home markets for yield and diversification benefits, but do not wish to take on the additional currency risk that accompanies them. Hedged Share Classes are a useful tool for them, since they are intended to minimize, but not completely eliminate, the effect of exchange rate fluctuations between the investment currency and the base currency. Their main objective is to allow foreign stakeholders to benefit from returns close to those of local investors.
The existence of this type of class is a very convenient option for final investors. It avoids the investor herself having to, first, convert her money into the foreign currency in order to participate in the fund and, second, worry about the possible hedging of the currency risk to which she is exposed. For the fund manager, offering this type of class means extending the reach of its products internationally.
For a better understanding, we are going to analyze some real funds. We have selected 15 USD funds from different fund managers with an available GBP Unhedged Class and a GBP Hedged Class. Therefore, the tuple (Reference (USD), Unhedged (GBP), Hedged (GBP)) exists for all of them. We summarize their results, correlations and divergencies in the following figure:
We can notice that…
- Both GBP Share Classes, Hedged and Unhedged, underperform the equivalent USD Class.
- However, the Hedged Share Classes result was much closer to each original class.
- The correlation with local returns is much higher for the Hedging options.
- Although the magnitude of the divergences for Hedged Share Classes is much lower, the dispersion between them is much higher. There is an outlier in the Hedged Share Classes divergences that catches our attention.
Why was the Unhedged divergence negative?
Because USD depreciated with respect to GBP during this period and, consequently, the USD/GBP movement deteriorated the USD investment .
Why are the Unhedged Classes divergences so similar?
Because they all are explained mostly by the spot movement.
The divergences are not exactly the same, because the reference performance itself produces differences on the spot impact; the order in which returns take place is important too. Besides, managing the conversion requires subscriptions and redemptions or even structural differences regarding funds’ fees may cause divergences too.
Why did the Hedged Classes underperform?
There are three factors that deteriorated results for sure:
- Swap Points: A forward contract consists of arranging a future price to execute a future transaction. This price depends on the Interest Rate Differential between the USD and GBP in our case. It could be either positive or negative, but it was negative considering the analysis period.
- Asset Value Uncertainty (or What cannot be hedged): It is possible to hedge the value of the underlying at the beginning of a period, but it is impossible to hedge the currency risk that arises from the variation of its value. These variations are mostly increases of currency risk, which turned into losses, in our example.
- Hedging Fees: All the transaction costs derived from the hedging trades and/or the hedging service fee will be borne by the Hedged Share Class.
Why are the Hedged Classes’ divergences so dispersing?
To hedge or not to hedge is just the first question. Once you decide to hedge, you need to determine how to do it. Forward contracts are the most extended practice. But which term? How often? What time? How much? There is quite a long list of other decisions to make that will produce different results.
- Timing Lag: The hedging transaction can only be placed after the fund’s valuation time point. Time execution will produce differences depending on the intraday volatility, since the execution price will change.
- Hedge Ratio Filter: The Hedge Ratio may not always be exactly 100%. Normally, minor adjustments are not done to avoid transaction costs.
- Target Hedge Ratio: Although Hedged Share Classes typically look to hedge 100%, there could exist exceptions where Target Hedged Ratio is lower. This is surely the case for the “O” class, the outlier in the figure, whose divergence evolution shows high correlation with GBPUSD spot.
- Unrealized Effect: Gains and losses generated by hedging are part of the valuation of the Hedged Share Class price. However, they are not realized until the maturity of the transactions and are therefore not reinvested in the base fund. In the example, the hedging produces losses, but they are not affecting base investment until their settlement date.
And, as we mentioned in the case of Unhedged, managing subscriptions and redemptions, which include conversion and hedging this time, as well as funds’ fees, may be different.
Although all the funds in the example are hedged, their impacts will depend on how the hedging management was carried out in addition to the interest rate differential. Therefore, their divergences with respect to their corresponding reference classes may seem very dispersed, since there are lots of different factors to take into account.