Traditional Share Class Hedging (SCH) consists of cancelling the exchange rate risk inherent in a share class denominated in a foreign currency, i.e. in a currency other than that of the fund. Hedging transactions necessarily entail costs that affect the client’s final result. It is therefore important to find the smartest way to carry out this hedge.
Refreshing Share Class Hedging
Hedged Share Classes are a good option for fund managers to broaden the scope of their products, offering them to international investors. The foreign investor will often want to have a return similar to that of the home investors, without having to deal with the currency risk present in an unhedged class.
However, the performance of the Hedged Share Class will never be identical to the performance of the underlying fund; there will always be some slippage effects. These include the interest rate differential between both involved regions, the transaction costs and the currency management fees, among others.
These effects drag the client’s returns. For this reason, overlay managers seek to offer more sophisticated products which fully or partially offset them, providing the end-investor with a return equal to, or even better, than that of the benchmark. Dynamic hedging strategies, for example, take advantage of the movements of the spot rates, leaving the exposure partially unhedged when they are favorable.
Here we are going to discuss Portfolio Hedged Share Classes, or “look-through” hedging; a passive hedging strategy that seeks to reduce transaction costs by minimising the number of trades.
Motivation
Let’s define the currency in which the Share Class is offered to foreign investors as Non-Base currency, and the currency of the fund as Base currency. For example, imagine an European fund (Base currency = EUR), that offers a Hedged Share Class in GBP.
When a UK investor buys this Share Class, the fund manager has to convert her money to the fund’s Base currency -EUR-. This operation involves an exchange rate risk. To override this risk, the currency manager opens a forward contract performing the opposite action. Namely, since the fund’s manager has sold Non Base currency (GBP) to buy Base currency (EUR), the currency manager would buy Non-Base currency.
So far, we are just talking Share Class Hedging. The crucial point is the following: the fund invests in underlying assets that might also be in different currencies. So there is a currency risk there as well. This risk is addressed with one (or several) Asset Hedging mandates, that seek to mitigate the effect of foreign exchange rate fluctuations between the Fund currency and the underlying assets currencies.
Asset Hedging mandates are similar to Share Class Hedging mandates, just in this case the Non-Base currency is the currency of the assets (Base currency is still the fund’s currency). The fund manager converts the fund’s money (which is in Base currency) to Non-Base currency, in order to invest in the assets. Thus, the operation of hedging is the opposite to the case of SCH.
Approaches to the problem
Summarising, for the situation of a Fund whose underlying assets are invested in foreign currencies, and that is offered to investors through a Hedged Share Class (SCH), we could hedge in two steps, using two different types of mandates.
However, there are advantages on hedging directly between the Share Classes and the Fund’s underlying assets, without going through the Fund’s base currency. That is why these Shares are also referred to as “look-through hedged shares”.
Currency hedging for this kind of fund can be implemented with two approaches:
- Individual: for each exposure (asset value and share class value), create an individual currency hedging mandate for each currency risk;
- Look-Through: the Share Class exposure is split into different lumps whose size corresponds to the weights of each underlying asset; these lumps are hedged individually as a standalone SCH mandate.
The main drawback of the Individual approach is that some hedging mandates could potentially cancel each other out, for example if one of the Share Class is denominated in the same currency as one of the underlying assets. Hedging these two exposures separately increases unnecessarily the costs, since they could partially offset each other.
What is a Portfolio Hedged Share Class?
By Portfolio Hedged Share Class (PHSC) or Look-through Hedged Shares Class, we understand the management of the currency risk in the hedging problem of a Fund whose underlying assets are invested in several foreign (or local) currencies (some may coincide with the Fund currency), and that is offered to investors through local or Hedged Share Classes (SCH) (i.e., the SCH can be denominated either in the Fund’s base currency or in foreign currencies).
PHSC mandates seek to reduce most of the effect of foreign exchange rate fluctuations between the Share Class currency and the other currency exposures of the Fund’s underlying assets. This risk could be managed in two different steps with two different mandates, one of the SCH type to mitigate the the exchange rate risk between the Share Class currency and the Fund currency, and one (or various) Portfolio Asset Hedged (PAH) type mandates to mitigate the exchange rate risk between the Fund currency and the underlying assets currencies. But this approach is less efficient.
Explanation by example
Let’s stick with the example of the European fund (Base currency = EUR), that offers a Hedged Share Class in GBP. Further imagine that it invests in assets in three different currencies: Euro (EUR), British Sterling (GBP) and Swiss Franc (CHF). The allocation percentages of each of the asset is shown in the following table.
The exchange rates involved in the problem are listed in Table 2.
That is, the total AUM of our GBP Hedged Share Class is allocated through the underlying assets according to these percentages -or weights-. In practice, these weights will vary on a daily basis, but we can assume we are talking just about one day here, so we don’t have to worry about that.
Now that everything is setted up, let’s throw in some action. Someone invests 100 GBP in our Share Class, so there is an inflow that has to be both converted and hedged.
There are two ways of hedging this Share Class: the individual approach, and the look-through approach.
Individual approach
One possibility is to tackle the problem in two separated individual stages:
- On one hand, the hedging of the exchange rate fluctuations between the Share Class currency and the Fund currency, which would be a traditional Share Class Hedging problem.
- And on the other hand, the hedging of the exchange rate fluctuations between the Fund currency and each of the underlying assets currencies.
If we have decided to approach the problem this way, then we would convert the 100 GBP to the fund’s Base ccy in the first step. And then, once we have the money in Euros, we would allocate it among the underlying assets and convert it to the assets’ currencies. Note that 50% of the money is allocated to EUR assets, and since the fund is already in EUR, we don’t have to convert that portion.
The whole set of conversion trades that need to be executed with this approach is shown in Table 3. It is clear that the GBP Share Class and Asset exposures partially offset each other. This is an issue, because it implies that we have traded more than required, leading to increased costs.
The hedging forward trades are exactly the opposite, with the difference that since they are forward contracts, their price would also have a swap points part, due to the interest rate differential. We are not going to reflect this here, for the sake of simplicity we assume that trades are done at spot prices.
Again, from Table 4 is clear that trade 1 and 2 partially offset each other, so we would have incurred unnecessary transaction costs by hedging in this way.
Look-through approach
The other option is to ignore the fund’s Base currency and hedge directly between the Share Class and the Underlying Assets. When the 100 GBP inflow appears in the Share Class, the money is divided in accordance to the allocation percentages and directly converted to the asset currencies.
Since one of the underlying assets’ currencies is GBP, which is the same as the Share Class currency, there is nothing to hedge there. We would be saving a hedging mandate.
We would have two SCH-like mandates. One between the GBP Share Class and the EUR assets, and the other between the GBP Share Class and the CHF assets.
The conversion trades needed to allocate the money in the correspondent assets are as follows:
And consequently, the hedging trades:
It is clear that both the amounts of the trades, and the number of transactions are smaller than in the former case. Consequently, this leads to cheaper hedging in terms of costs: the appropriate exposure is hedged with smaller notionals.
Although Portfolio Hedged Share Classes might seem complicated in theory, they are worth the effort. We can conclude PHSC mandates are a more efficient and simpler way to hedge in these situations, as they lead to the minimal number of transactions, reducing costs and operational risks.
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