Hedged share classes – What’s hiding behind the hedge?

Many investment funds holding assets denominated in foreign currencies also offer their clients the option to invest in a share class that eliminates the resulting currency risk – a hedged share class. In this article, we investigate the effectiveness of these share classes in hedging currency risk and adding value to an investment portfolio, particularly when compared to a specialized currency overlay manager.

The currency hedging process & the interest rate differential

Our analysis takes the perspective of a Swiss based investor who is concerned by the value of his US investments in CHF and wants to see this value unaffected by changes in the USD/CHF exchange rate. Because the original investment involved buying USD assets using an amount of money in CHF, the hedge is made up of the opposite transaction (i.e. selling the corresponding amount of USD versus CHF). Normally these transactions are made using forward contracts due to their flexibility, cost-effectiveness and price transparency.

 

By selling forward the USD/CHF, the investor effectively has a debt in USD and a savings account in CHF that will both incur the interest rate prevailing in the respective countries. One quickly realizes that if the interest rate of the USD is higher than that of the CHF – as has been the case in recent years – the hedge entails a cost corresponding to the interest rate differential between the two currencies. Given that a typical Swiss pension fund has around 60% of its foreign assets invested in USD, an interest differential of -3.06% (as was the case in 2018) represents a sizeable drag on the overall portfolio’s performance.

Methodology

Our analysis includes data from 66 investment funds marketed to institutional investors in Switzerland which are labeled in USD and which also offer a corresponding hedged share class in CHF. These funds are invested in USD-denominated bonds or equities, have publicly available and precise enough annual performance numbers (at least for 2018).

Direct costs

We start by evaluating the funds’ fee structure in terms of ongoing charges. 22 of the 66 funds charge higher fees for their hedged share class while the remaining 44 do not. The size of these additional hedging fees ranges from 1 to 12 basis points per year, with an average of 5 basis points. In contrast, a specialized currency overlay manager would typically charge 1 basis point to implement a similar passive hedge.

Number of funds with hedging fees

22

Number of funds without hedging fees

44

Average hedging fee

0.05%

Median hedging fee

0.04%

Best hedging fee

0.01%

Worst hedging fee

0.12%

Indirect costs

Although a majority of funds in our sample do not charge additional fees for their hedged share class, this does not tell the whole story. A complete picture is only obtained by comparing the bottom-line performance of the hedged and unhedged share classes. We measure the yearly performance of the different share classes from 2011 to 2018 (when available) with data extracted from the funds’ issuers monthly reports. For each fund, the difference in performance between the hedged and unhedged share classes should reflect the total cost of hedging for a given year – that is the interest rate differential between the CHF and the USD plus some implementation costs.

In other words:
Hedged Performance – Unhedged performance = Interest rate differential + Implementation costs

very year, we compare the average hedging cost of the hedged share classes to that of a specialized currency overlay manager with a similar USD/CHF passive hedging objective. We plot the cumulative costs of these two approaches in the accompanying graph. Since both hedging approaches are impacted equally by the interest rate differential, any difference in performance between the two is due to varying implementation costs, further discussed in the next section.

Over the 8 years of our sample, passively hedging the USD investments using the hedged share classes has resulted in a -11.31% cumulative cost versus -9.09% for the specialized currency overlay manager.

In order to evaluate these results from a different angle, we illustrate below the yearly under- or outperformance of individual funds in the form of a histogram. 79% of the observations are situated to the left of the red vertical line set at 0 meaning that on an individual basis the funds have underperformed the specialized manager in nearly 80% of cases. This translates into a yearly average of -0.15% indicated by the blue dashed line.

Interestingly, only 8% of the hedged share classes outperformed the currency specialist for more than 1 year.

Possible causes for this underperformance

Due to limited information being publicly available on the different funds, we were unable to precisely identify what explains the size of the underperformance in hedging, as well as the divergence between funds. However, our research suggests the following factors are at play:

Unrealized profit & losses on forward contracts

Since forward contracts are typically rolled over on a monthly basis (weekly in cases of extreme asset and/or currency volatility), they carry unrealized profits and losses. While they are accounted for in the NAV computations, these unrealized profits and losses are only added to or subtracted from the fund’s investments when forward contracts are rolled over, thereby foregoing potential investment returns or losses.

Frequent and desynchronized adjustments of the hedge

Although the NAV and the hedge amount are reevaluated on a daily basis to account for changes in market prices and any new subscriptions or redemptions, they often do not occur at the exact same time which may result in a hedge mismatch. Moreover, these frequent adjustments incur transaction costs that quickly add up. In an attempt to mitigate this issue, a 95%/105% buffer for the hedge ratio is sometimes applied by the funds.

Investments in other currencies

Despite the fact that we screened for funds supposed to be solely invested in USD, some funds reserve the right to invest a fraction of their pool (up to 30%) in other currencies in an attempt to outperform their benchmark. Such investments would deviate the hedge from a pure USD/CHF one and may explain the under-performance (and outperformance) for some funds.

Sub-optimal trade execution

When the hedge is made in-house by the fund issuer, the hedging process may not be regarded as critical as the management of the underlying investments and thus may not undergo a thorough analysis. This stands in contrast with a specialized currency overlay manager’s duty to achieve and demonstrate the best implementation of the hedge for their client.

External management of currency risk

In theory, a specialized currency overlay manager will be able to provide their clients with important benefits in comparison with what was presented above. In particular:

  • Low and transparent management fees of 1 basis point (0.01%) per year for passive hedging
  • A diversified operational risk by separating asset and currency management processes
  • An independent service with an aligned interest to get the best hedging cost for the client
  • A tailor-made hedge ratio and rebalancing schedule
  • A transparent, optimized and documented execution process (including an internal and external Transaction Cost Analysis (TCA) which are now market standard)

We illustrate these benefits by conducting a case study below where we compare over different time periods:

  • The performance of a fund in USD held by the client of a specialized currency manager including the associated passive hedge, and
  • The performance of the CHF currency-hedged share class of the same fund.

Since the underlying investment is exactly the same in both cases, this comparison has the advantage of controlling for part of the factors listed in the section above and allows for a direct comparison of the hedging performance. The results are summarized in the table below:

Reducing the impact of the interest rate differential

Contrary to passive hedging strategies which aim to eliminate the impact of currency fluctuations at the cost of the interest rate differential, dynamic hedging strategies adapt the hedge ratio to market conditions. These dynamic hedging strategies are tailored to the investor’s risk profile, philosophy and their preference in terms of limiting the size of incoming and outgoing cash flows. In a typical “0% benchmark” mandate, the currency manager is able to vary the hedge ratio from 0% (no hedge) to 100% (fully hedged). The goal is to apply a hedge only when the foreign currency is expected to depreciate and to adapt the size of the hedge based on the magnitude and probability of the anticipated move. With a “50% benchmark” mandate, the manager can both increase and decrease the hedge relative to the default case. In this setup, an appreciation in the foreign currency can also be benefited from. Thus, the flexibility provided by dynamic hedging has the potential to bring considerable value to an investor’s portfolio by not only reducing currency risk but also adding positive returns.

The passive overlay program set up by the specialized currency manager for its client has consistently outperformed the currency-hedged share class offered by the fund issuer over the two periods under consideration. While the outperformance is already significant over one year (0.09%), it compounds to 1.82% over four years thus substantially outweighing the direct cost associated with the specialized currency overlay manager.

The histogram indicated that the yearly average outperformance of the dynamic program is equal to 2.83% with individual hedged share classes underperforming in 90% of cases.

Conclusion

The analysis we performed in this article seems to indicate that hedged share classes, although they may be a practical one-stop way to hedge one’s foreign currency exposure, significantly underperform equivalent passive overlay programs set up by specialized currency overlay managers. The sources of this performance drag are not easily identifiable due to opaque hedging processes, but unrealized profits and losses on forward contracts, frequent and desynchronized adjustments of the hedge, investments in other currencies and sub-optimal trade execution appear to all play a role. A dynamic overlay program adapts the hedge ratio to market conditions according to a manager’s investment process, allowing one to limit losses and add gains to their portfolio. For Swiss-based investors in particular and due to the size of the interest rate differential, this approach turns out to be a valuable addition to their portfolio management toolbox.

Authors

This article was written by two members of the Perreard Partners Investment team.

If you want to learn more, don’t hesitate to come to our booth at the PPS Show in Lausanne, May 15th and 16th!

Ehsan Kamel
Business Development Switzerland
PPI_Jonas-Demaurex
Jonas Demaurex
Research