Crossing Borders with Share Class Hedging

Crossing Borders with Share Class Hedging Image

As small to midsized asset managers look to expand globally, they should be evaluating share classes as a tool to deliver a common investment strategy to a range of investors. While some share classes are straight forward, foreign currency share classes are not.

Jay Moore explains what you need to know about currency hedged share classes as an integral part of a global asset managers’ distribution strategy.

What’s the difference between the mild and wild success of an investment management firm’s global distribution strategy? The answer is a well-implemented, share class hedging program.

Established firms have been using currency hedged share classes as a central part of their distribution strategies for years. Today, small to midsized managers are looking to expand their global footprint as more sophisticated tools providing scale and cost effective solutions have become available.

Share classes have been central in delivering a common investment strategy to a range of investors. Typical share classes include (i) retail versus institutional, (ii) income reinvesting versus distributing, (iii) share classes with varying fee structures, and (iv) share classes denominated in foreign currencies.

The final category presents a unique risk that the other class types do not: foreign exchange risk.

Take, for example, a US manager with a best-in-class track record. Regardless of the specific investment strategy (fixed income, equity, domestic, global, etc), the track record has been measured and published in USD terms. This USD performance draws the attention of international investors looking for top managers not only in their home country, but globally.  Should a European based investor looking for the top performing global equity manager be limited to managers based in Europe? Probably not — because quite simply, the best talent is not always in your own backyard.

However, investing in funds or classes with denominations in a foreign currency exposes investors to foreign exchange risk that can dramatically alter the performance profile of the investment.  This is where currency hedged share classes come in.

The primary goal of the currency hedged share class is to replicate the base currency returns of a fund to any number of foreign currency classes without the uncertainty of exchange rates in the translation. For example, an investor in Paris can buy a hedged EUR share class of a fund managed in New York.  This share class should deliver the performance of the core investment strategy, while hedging the potential appreciation or depreciation of the fund’s or portfolio’s currency (USD) relative to the investor’s currency (EUR).

The best way to measure if a hedged share class delivers the performance of the core investment strategy is in terms of “tracking error”. In this context, “tracking error” is defined as the uncertainty (standard deviation) of return differences between the fund in base currency terms and the currency hedged share class. The less variation in daily return differences (tracking error), the more representative the share class performance is of the fund strategy and ultimately the more likely the share class performance will meet the return objectives.

While the concept of share class hedging may seem straightforward, delivering an effective hedged share class can prove difficult. Due to the complexities of implementing and maintaining a hedging program, managers must first determine whether they will handle the program in-house, or if it is better suited for a specialist hedging provider. The decision can be evaluated by asking two basic questions:

  1. Is this considered a core competency or an operational burden that introduces uncompensated risks?
  2. Am I equipped to provide my internal and external clients with the level of transparency and detail required to validate the effectiveness of my hedging program in a world of increased scrutiny on cost and performance?

After considering these questions, managers often agree that they are better served to direct their precious resources to strategy performance, their true differentiator.

If a manager decides to run the hedging program in-house, it is important to avoid simplicity over precise implementation – a sub-optimal process can lead to sub-optimal performance. The seemingly minor decisions around contract tenor, trading filters and rebalance frequency can have a profound impact on the effectiveness of the hedge. When a share class hedging program is not properly calibrated, these decisions can lead to unwanted tracking error, under-performance and high trading costs, ultimately weakening the strength of the investment product.

Beyond this abbreviated list, there are a slew of implementation factors that can make the difference between a well-oiled machine and a disaster waiting to happen. This difference can be the edge that sets your investment product apart in a market where competition is fierce and standards are rising. The decision to offer hedged share classes is an important first step in advancing your distribution strategy. A well-implemented program can tear down cross-border distribution barriers and arm your sales team with an arsenal of investment choices for potential investors across the world.