Hedged share classes - UK mutual funds
An explanation
February 2016
This document is for investment professionals only and should not be distributed to or relied upon by retail clients. It is only intended for use in
jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required.
Why operate currency hedging?
The effect of hedging – an example
There is merit in investing overseas and gaining
access to the world’s equity, bond and property
markets. There are also some risks, and one of
the most important is that of adverse currency
movements. When you invest internationally,
typically you gain exposure to both the
underlying asset and the currency.
Chart 1 illustrates the difference in returns
from investing in an international market in
sterling terms and in local currency terms.
Effectively, it shows the return for a UK sterling
investor investing in Japanese equities over
the last five years with and without sterlingyen exposure. By continually hedging currency
exposure over this period, i.e. removing the
effect of sterling-yen currency movements
on performance, a UK sterling investor could
have achieved a return closely matched to the
Japanese yen investment return.
Investing in hedged share classes is one of
the most effective ways of mitigating the risks
of currency volatility in situations where the
investment currency of the investor differs from
that of the underlying assets held by a fund.
An unhedged share class will deliver a
combination of market and currency return
whilst a hedged share class will aim to deliver
market return only.
At Standard Life Investments, we offer hedged
share classes for a selection of our funds.
This gives investors who are targeting a return
from international markets greater flexibility
by offering the choice between hedged and
unhedged access.
Key messages
¬Hedged share classes are an
alternative investment option for
investors accessing international
markets.
¬Hedged share classes aim to minimise
currency exposure between the
currency of the share class and that of
the underlying assets of the fund.
¬Although hedged share classes do
not provide a perfect hedge, a robust
process and strict controls are in place
to provide an effective outcome.
The chart below shows that there are some
periods in which returns in sterling terms
were better; there are also some periods
where performance in yen terms (i.e. without
the sterling-yen currency impact) was better.
While there is nothing wrong with trying to gain
additional returns from currency, it can be a
significant additional risk and may well be one
that the investor will not want to incur. In the
end, it is the investor’s decision whether to
take a view on the currency or opt for a
hedged share class.
Chart 1: MSCI Japan index
200
150
100
50
2009
2010
2011
2012
2013
2014
2015
2016
MSCI Japan (JPY)
MSCI Japan (GBP)
Source: Thomson Reuters Datastream, total returns
for period 31/12/2008 to 17/2/2016.
Past performance is not a guide to the future.
How does it work?
Hedging is undertaken on our behalf by
Citigroup, using their currency hedge
administration service and based on hedging
rules set by Standard Life Investments. The
overall hedging position is monitored daily and
adjusted as necessary in accordance with these
rules. We have a specialist in-house currency
team which has oversight of the process and
perform daily checks.
Currency-forward contracts are used by
Citigroup to buy or sell foreign currency at
a set date and price. Hedging in this way
guarantees the rate at which foreign currency
can be exchanged into sterling at a given point
in the future. Sensible tolerance bands bands,
as defined by Standard Life Investments, are
used to keep the hedged position close to the
target level whilst keeping transaction costs
to a minimum. The currency-forward positions
remove unwanted foreign currency risk and, in
so doing, effectively convert unhedged returns
into hedged returns.
Technical explanation: The hedging process
Taking the Japanese Equity Growth Fund as an example, the fund is priced in sterling but holds
assets priced in Japanese yen. The hedged share class maintains a currency hedge using
one-month, over-the-counter, currency-forward contracts, selling Japanese yen to buy sterling
one-month forward.
Each hedged share class has a target hedge ratio and a tolerance limit around this target ratio.
For the Japanese Equity Growth Fund, the target hedge ratio is 100% and the tolerance limit
is +/-3%. If, on any day, the value of the share class moves outside the tolerance limit then
the hedge position will be rebalanced. This is accomplished either by putting on an additional
hedge or closing out part of the existing position. Any adjustments are put in place so that
they expire at the same time as the original hedge. Modifications are also made to the hedge
position for daily subscriptions and redemptions.
The profit or loss generated by the hedge is accrued within the share class value on a daily
basis and settled at the end of the hedge period. In certain circumstances, the end of the
hedge period may be brought forward and the profit or loss will be settled at an earlier date.
This may be to protect the share class in periods of high currency volatility or if the profit or
loss is becoming too large a proportion of the share class.
Performance
The performance of the hedged share class aims to reflect the performance of the assets held by the fund
in the local currency and will include the profit or loss, and associated costs, from the currency hedge.
Please note, however, it is not possible to provide a perfect hedge. Interest rate differentials on
the foreign exchange contracts are one source of divergence. Another practical issue is that to
exactly match the net asset value of the share class on a day-to-day basis would require multiple
small adjustments which, in turn, would generate higher costs. Hence, the use of tolerance bands
reduces the frequency of these adjustments.
Important Information
Switching into or out of a hedged share class may be treated as a disposal for UK Capital Gains Tax
purposes. Investors should consult their tax adviser.
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standardlifeinvestments.com
This material is for informational purposes only. This should not be relied upon as a forecast,
research or investment advice. It does not constitute an offer, or solicitation of an offer, to sell
or buy any securities or an endorsement with respect to any investment vehicle. The opinions
expressed are those of Standard Life Investments and are subject to change at any time due to
changes in market or economic conditions.
Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments Limited is
authorised and regulated by the Financial Conduct Authority. Calls may be monitored and/or recorded to protect both you and us and help with our training.
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