Securities and Fund Services
Citi OpenInvestorSM
Share-class hedging comes of age
The ability to offer hedged share classes is increasingly seen as one of the keys to successful
fund distribution. By removing currency considerations at the fund unit level, hedged share
classes expand the universe of investors to which a manager can market a fund.
As UCITS legislation has made it progressively easier to market
funds cross-border in Europe and increasingly into Asia and
Latin America, so hedged share classes have taken on added
importance. “There has been a significant increase in the
number of funds going down this route,” says James Lemon,
Global Product Head of FX for Citi’s Securities and Fund
Services division. “Initially it was Dublin or Luxembourg based
funds that led the way — for the obvious reason that they were
launched to be sold internationally. But increasingly we are
seeing UK-domiciled funds add hedged share classes, too.”
In many cases, this is not just to make them more
marketable abroad, but to offer investors a more attractive
fund and expand the geographic footprint of the investor
base to which the fund is being marketed. This approach
also aims to remove any exposure to the fund base currency
while it closely tracks the overall performance. Ultimately,
this should attract more investments into the funds.
But not everything is straightforward. There is some debate
within the funds industry about the appropriateness of
hedged share classes for all asset types. Most industry
participants agree that hedged share classes reduce the
delta in performance between the fund base currency share
class and those denominated in other currencies. “But some
managers believe where this may be particularly valuable
for Fixed Income Funds given their relative sensitivity to
performance derived from currency fluctuations, it may
be less so for equities along the same lines as we have
seen from those entering into portfolio hedges” says
David Holloway, Share Class Hedging Product Manager,
EMEA, for Citi’s Securities and Fund Services. Citi analysis,
for instance, shows that, on average, 100% hedging with
currency forwards reduced the annual volatility of the
World Government Bond Index from 8.7% to 2.5% for
US investors, from 9.7% to 2.6% for euro zone investors
and from 8.6% to 2.6% for UK investors over the period
between January 1999 and July 2013.
Hedging was particularly effective in 2008 and 2009 when
currency fluctuations added an unprecedented amount
of risk to international bond portfolios. All told, currency
hedging materially improved the risk-adjusted return for
bond portfolios over the period studied.
Currency risk is less important in equities, which are
naturally more volatile than bonds. Analysis over the same
period showed only a modest reduction in annual volatility
in the MSCI World Equity Index. In the crisis years of 2008
and 2009, currency hedging was effective for US investors
but had the opposite effect for euro zone investors.
At Old Mutual Global Investors (OMGI), Product
Development Director Richard Massey agrees that hedged
share classes are “fundamental” to distributing funds
cross-border. But there are other issues, too, which affect
any decision on whether to offer a hedged share class or
not: “Our default position is that we offer hedged share
2
WGBI Non-USD
WGBI Non-EUR
WGBI Non-GBP
230
230
180
180
130
130
240
220
200
180
160
140
120
100
80
80
99
01
03
05
07
100% hedged into USD
09
11
13
80
Unhedged USD
99
01
03
05
07
100% hedged into EUR
09
11
13
99
Unhedged EUR
01
03
05
07
100% hedged into GBP
MSCI Non-USD
MSCI Non-EUR
MSCI Non-GBP
160
180
180
140
140
100
100
09
11
13
Unhedged GBP
110
60
99
01
03
05
100% hedged into USD
07
09
11
13
Unhedged USD
60
99
01
03
05
100% hedged into EUR
classes for our fixed-income funds unless discussions with
intermediaries suggest that investors will not be interested.
Equities are different. There is less transparency over
the currencies in which the cash flows are generated.
British companies are a good example: a big chunk of their
revenues arises in US dollars or euros. So a hedged share
class for a GBP equity fund is not really relevant.”
The one exception is absolute return equity. Dan
Cunningham, OMGI’s Head of Investment Operations,
says: “The target is usually expressed as cash plus 3%
in sterling. If you are going to market that to European
investors, you really have to offer that in hedged form
so you deliver the same return in euros.”
Hedging options multiply
As share-class hedging has increased in popularity, so the
variety of hedging options and techniques has multiplied.
Citi has been working with clients on implementing and
managing share-class hedging since 2006, and it has led
the way with new techniques. The plain-vanilla approach
is to ensure that close to 100% of the NAV is always
hedged. That means adjusting regularly both for changes
in NAV and for flows in subscriptions and redemptions.
However, a manager may want to avoid having to put a
new hedge in place every time a few hundred shares in the
fund are traded. Assuming the management of the hedging
process has been outsourced to the fund’s administrator or
another bank, the manager will normally agree a tolerance
level with that bank at the outset so that new hedges are
only triggered once the hedge ratio falls, say, below 97.5%
or above 102.5%. Minimum deal sizes may also be agreed.
Typically, a fund’s exposure will be hedged by entering
into a forward contract at the start of each month to
mature at the end of that month. New forward contracts
07
09
11
13
Unhedged EUR
60
99
01
03
05
100% hedged into GBP
07
09
11
13
Unhedged GBP
will be taken out as required through the month — all
maturing on the same day as the base contract. All are
then rolled forward together and the monthly cycle starts
again. Forward hedges are simple and effective.
Partial hedging
One alternative to the vanilla approach, developed by
Citi in partnership with its clients, is partial hedging.
This is an option for balanced funds, made up of a
mix of equities and fixed income. For all the reasons
mentioned above, some fund managers consider hedging
appropriate for fixed income but not necessarily for
equities. The partially hedged share class mirrors the
equity/fixed-income split within the portfolio by hedging
only that proportion of the NAV exposure represented by
fixed-income securities. By excluding the value of equity,
the hedge may become smaller with lower costs thus,
reducing the performance drag on the share class.
“The proportion of the share class value included in the partial
hedge,” says Holloway, “is derived from the percentage of the
fund’s NAV allocated to fixed-income assets. This is updated
dynamically with each fund-valuation event.”
OMGI uses Citi’s partial hedging solution for three of its funds.
“We hedge all non-equity securities for the International
Growth and Diversified Fund,” says Cunningham.”
Retro rate on subscriptions and redemptions
Funds that face large subscription or redemption flows
in their hedged share class face a risk of dilution from
sharply moving currency rates. While the daily NAV will
typically be fixed at noon, the fund’s transfer agent will
not be able to report the cash value of all the trades
until 16.00 or even later. As a result, subscriptions and
redemptions may be accounted for at the midday rate
but achieved at another.
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Where swaps are used as the hedging instrument, Citi
now offers a retro-rate solution to this problem. It applies
the same spot FX rate used in calculating the NAV — to fix
the near leg of the swap. “The exposure we have is the
movement in the forward leg over the intervening hours,”
says Lemon, but the benefit to the client is reduced
dilution to the fund from the conversion of the investor
flow between share class and fund currency.
“Our clients,” he says, “are using our retro-rate solution to strip
out this dilution effect.”
Look-through share-class hedging
Citi has been working with clients to devise an innovative
solution to an age-old problem of hedging both at the share
class and portfolio level where for example a USD fund has
a EUR share class and is heavily invested into the Eurozone.
Hedging at both levels is un-necessary and adds to the cost.
“The solution is a look through hedge,” says Holloway, “you
hedge once and only for the proportion of assets represented
by the hedged share class as a proportion of the overall NAV.”
“The aim is to hedge all the exposures but only for the
hedged share class”, says Lemon. “Look-through shareclass hedging effectively delivers a currency overlay that is
applied only to the proportion of the portfolio represented
by the relevant hedged share class.”
The concept has already proved itself. OMGI has been an
early adopter.
Range of execution options
The retro-rate model for subscriptions and redemptions is
just one example of the different execution options Citi has
For more information, please contact:
Cathal O’Daly
EMEA Client and Sales Management
Ireland
+353 (1) 622 6260
[email protected]
Richard Street
EMEA Client and Sales Management
+44 (0) 20 7500 5043
[email protected]
Liquidity, flexibility, high-quality reporting
There are three parts to the share-class hedging
solution that must be considered.
Liquidity. Work with the market leader in FX. Examine
which banks will publish benchmark rates at regular
fixing times and agree to deal on them, something
which Citi does.
Flexibility. You need a range of hedging solutions and
execution options that can fit with your approach.
Reporting. Make sure you have clear, detailed
reporting delivered in a usable and jargon-free
fashion. Moreover, all FX solutions should be fully
transparent, and supported by a full audit trail.
developed to maximise the transparency and effectiveness
of share class hedging.
Transparency of FX pricing is essential. For NAV adjustments,
Citi offers a range of options. Clients can choose either a
market quote, which is processed immediately, and therefore
reduces any tracking discrepancy, or Citi benchmark
rates, which are fixed 17 times a day. In all cases, deals are
transacted on an agreed spread and time-stamped.
Performance
Ultimately, you need a solution that gives you liquidity,
flexibility and high-quality reporting at the right price
so you can focus on what matters to you and your
investors – performance.
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individual needs.
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