It is important to note that currency hedging is never perfect – it seeks to reduce the impact on performance of exchange rate movements between the fund’s currency exposure and the investor’s chosen currency, but it cannot eliminate that entirely.
Currency hedging at M&G is undertaken on a ‘replication’ or ‘look-through’ basis, depending on the fund involved.
Replication is a manner of currency hedging in which the base currency of the fund is hedged by taking out currency forward contracts equal to the net asset value of the share class. The aim is, as far as possible, to replicate the performance of the base currency share class. It does this by reducing the risk to the hedged share class from fluctuations between the currency of the hedged share class and the base currency of the fund.
Replication case study: M&G Optimal Income Fund
For investors outside the UK, we offer a number of currency-hedged share classes for the M&G Optimal Income Fund. These seek to reduce the impact on performance of exchange rate movements between the fund’s base currency, sterling, and the currency to which the investor is exposed. The result is that these share classes deliver performance to non-sterling-based investors similar to that for sterling investors.
Look-through share-class hedging seeks to mitigate the impact of currency movements on those holdings of the fund that are denominated in currencies other than the currency of the hedged share class. It involves a ‘line-by-line’ approach, where each currency is hedged individually.
Look-through case study: M&G Global Convertibles Fund
The M&G Global Convertibles Fund is invested across a wide range of currencies. Provision of a currency-hedged share class requires that exposure is hedged on a line-by-line basis. For example, all US dollar exposure will be hedged against moves in the dollar against the share class currency; all sterling exposure will be hedged against moves in sterling, and so on; exposure in each share class currency is not hedged. The net effect is approximately the same as holding a fully currency-hedged portfolio.
Fund manager currency views
It is important to note that replication hedging at the share class level retains the impact of any currency positions taken by the manager for the underlying portfolio. This is not the case with look-through hedging, in which all currency positions are hedged to the share class currency.
The hedging of currency-hedged share classes for the M&G funds is undertaken by State Street, a specialist provider of such services that is able to offer currency hedging at a competitive rate.
State Street implements currency hedges daily. We have agreed tolerance ranges within which State Street seeks to manage the hedging of our share classes. These are close to, but not exactly, 100%. M&G monitors State Street’s hedging operations for its funds on a quarterly basis.
Hedging accuracy and performance differences
With share class hedging there will always be an element of deviation, which can at times be significant, from the performance of a theoretically perfectly hedged share class, due to the imperfect nature of the hedging process. We can identify five possible sources of this difference, as follows:
1. Interest rate differential (IRD)
A forward foreign exchange (FFX) contract is priced on the basis of the spot rate and the difference between the interest rates on the two currencies.
For example, if interest rates are 4% in the UK, but 2% in the eurozone, the pricing of a three-month contract would take into account the 0.5% (one quarter of the annual rate) extra interest that an investor would earn holding sterling rather than the euro.
During periods when interest rates across currency areas are very similar, the IRD is very small with a low impact on hedged share class returns. However, in an environment where interest rates are significantly different between the fund’s exposure currency and the hedged share class currency, the IRD will be higher and the performance difference will be greater.
There is also a risk that in dysfunctional markets, the pricing of FFX contracts does not reflect the interest rates of the relevant currencies relative to contract duration. In this scenario, the interest rate differential cannot be relied upon to operate as in the example above.
2. Unrealised profit and loss
During the life of an FFX contract the exchange rates between the two currencies will fluctuate around the rate set in the contract. This will result in a notional profit or loss which is not ‘real’ until the contract is closed and cash is paid out. The amount of profit or loss has to be accounted for in the net asset value of the hedged share class but it cannot be invested by the manager. If an open FFX is in profit, this amount is effectively a cash drag on performance until the contract is closed out, and vice versa if the contract is in loss.
3. Implementation costs and asset value uncertainty
Taking out FFX contracts to hedge currency exposure involves transaction costs. The more frequently the hedge position is adjusted (contracts are rolled or new ones are taken out) then the higher will be the transaction costs.
In periods where the NAV of the hedged share class and/or exchange rates are volatile then transaction costs will be higher. For share classes with more volatile NAVs the level of hedging imperfection will be greater and more frequent FFX trades may be required.
In order to reduce transaction costs, M&G operates a buffer either side of the target hedge ratio so that a new contract is only taken out when the buffer is breached.
4. Timing differences
Due to the time required to value the share classes each business day and prepare hedging activity, there is a gap between the valuation point of the fund at midday and the time at which the currency hedges are implemented (typically 17:00-19:00). This can lead to the hedged share class being over- or under-hedged for a short period of time.
5. Lack of forward contracts
Not all currencies have appropriate currency forwards and in such cases, may be hedged using a proxy, ie a currency that is reasonably correlated to the asset currency. If a suitable proxy cannot be identified, it may be left unhedged.
There is an additional cost to currency-hedged share classes. A share class hedging fee is disclosed in the fund prospectus. The same fee applies whether hedging is undertaken on a replication or a look-through basis.