Share class hedging
What is currency hedging?
Hedged share classes minimise the impact of foreign exchange rate movements by attempting to eliminate the exposure of the hedged share class to the base currency of the fund. Aurum’s portfolios are currently all US dollar-denominated. A non-US dollar investor who wishes to capture the investment performance of one of Aurum’s funds, whilst substantially minimising exposure to fluctuations between their base currency and the US dollar, can invest in a hedged share class.
How does currency hedging work?
Aurum uses a NAV hedging method; this aims to provide a return that is closely related to the performance of the fund’s base currency class. The hedging is done using forward contracts which are used to offset the effect of exchange rate movements between the fund’s base currency and the share class currency.
For example a subscription into a sterling hedged share class of a US dollar base currency fund would work as follows:
- The investor purchases sterling shares, the proceeds of which are converted into US dollars (the fund’s base currency) using the spot rate on the NAV date.
- The converted US dollars are then invested in underlying US dollar-denominated assets, with the resultant US dollar currency exposure then hedged back to sterling using forward currency contracts, by “selling forward” the same amount of US dollars.
- The gain or loss on the currency hedge is reflected in the NAV calculation for the sterling share class and therefore in its performance. It is booked as an unrealised profit or loss on the balance sheet until the forward contract is rolled, at which point the profit or loss of the forward contract is crystallised and a new forward currency contract is put in place.
- This should substantially offset the gain or loss of the US dollar-denominated asset in the investor’s local currency, which in this case is sterling.
What are the likely performance considerations?
- The goal of hedging is to limit the effect of currency movements, rather than to make money (or avoid losses).
- Currency hedges will never be perfect. Hedged share classes aim to substantially minimise currency exposure, though will not completely remove it.
- The interest rate differential will be the main source of variance between the performance of the fund’s base currency share class and that of a hedged share class. This will have a positive or negative impact depending on the prevailing difference in interest rates.
- For example, if a fund returns 5% in US dollar terms, the base currency share class, the aim of the hedged share class is to return close to 5% as well. However, if the interest rates in the respective countries are different, then the returns will differ.
US dollar Libor 0.25%
Sterling Libor 0.50%
Interest rate differential +0.25%
Sterling hedged share class return 5.25%
- Transaction costs are incurred when executing forward contracts, however these are marginal. Foreign exchange markets are extremely liquid with over $5.3trillion of volume traded each day.
- If the fund makes outsized returns, either positive or negative, this additional performance will sometimes be under-hedged (in the instance of positive performance) or over-hedged (in the instance of negative performance). This is simply due to the fact that no-one can predict what the performance of a fund will be and so the currency forwards that are executed only hedge the market value of the fund at that point.
- One should be cognisant that, by investing in a hedged share class, one will miss out on any positive returns from currency movements, though will also be protected on the down side. For example, an investor in the sterling hedged share class will not benefit from the US dollar strengthening against sterling, but will be protected should US dollar weaken against sterling.