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  Active Strategies - currency hedging that can deliver smarter risk management

Exchange rate volatility and the management of hedged share classes

Eamonn Fallon

"...investors in hedged currency share classes, as a general rule, cannot expect performance returns to match exactly those of the base currency share class."

Funds of hedge funds (FoHF), especially those managed in Europe, frequently use currency class hedging as a means of attracting additional capital. As many FoHF are managed in dollars with a primary investment objective of the accrual of a dollar-based return, Euro or Sterling-based investors can be reluctant to invest due to the associated foreign exchange risk. Through investment in a hedged currency share class, an investor can gain exposure to the base performance return of the FoHF while mitigating the effect of exchange rate fluctuations between the invested currency and the base currency. FoHF that offer Euro and Sterling-hedged currency share classes are therefore a more attractive investment opportunity to these clients.

Background

Hedged currency share classes are managed so that class returns are closely correlated with the fund's base currency shares. This is typically arranged through the use of a forward FX contract, which is a deal to exchange currencies at a designated time in the future at a price agreed now. Forward FX contracts are an attractive method because of their comparatively low cost and the existence of a relatively liquid execution market. The profit and loss associated with the hedges will be attributed entirely to the respective hedged currency share class.

The most common dealing cycle for a FoHF is monthly, and FX contracts on the hedged classes therefore tend to be rolled on a monthly cycle. At the end of the month, the existing FX contract is closed out and a new forward FX contract with a value of the latest net asset value for the hedged currency class is executed with a settlement date of the following month end. Subscriptions and redemptions on the classes are treated similarly. For subscriptions, a spot deal is executed to convert non-base currency subscriptions to base currency and the base currency equivalent is sold forward. The exact opposite takes place for redemptions.

Imperfection of currency hedging

However, investors in hedged currency share classes, as a general rule, cannot expect performance returns to match exactly those of the base currency share class. While interest rate differentials on the forward FX contracts will always cause a reconcilable divergence, there are other issues that only allow investment mangers to manage the hedged currency share classes on a best efforts basis.

One of these is the effect of changes in the market value of the FoHF. Consider a Sterling hedged currency class with a share in the fund's assets totalling US$10,000,000. Selling US$10,000,000 to buy Sterling perfectly hedges the exchange rate exposure for as long as the net asset value of the assets remains the same. However, any movement in the dollar asset value will reduce the effectiveness of the hedge. For instance, if the value of the Sterling hedged currency class's assets appreciates by 25% to US$12,500,000, the share class remains hedged only for the original value of US$10,000,000. The differential of US$2,500,000 (20% of the share class value exposure) is therefore left unhedged.

To keep the currency as fully hedged as possible, FoHF will assess the need for adjustments each time the NAV is prepared, including potential interim adjustments based on estimated valuations. However, because future movements of NAV are unknown, adjustments to hedges to take account of market value changes on a FoHF's portfolio can only ever be considered in arrears.

Liquidity concerns on FoHF

Because they invest in less liquid strategies, FoHF have been hit particularly hard by losses on FX trades. Generally, FoHF are able to mitigate problems caused by their lack of liquidity through the application of various restrictions and guidelines. For instance, they require investors to give a specific period of notice for redemption requests, with 30 to 90 days being the norm. This notice period provides the fund manager sufficient time to raise the proceeds to finance the redemption and are essential to the effective functioning of the FoHF. However, because restrictions such as these cannot be applied to FX trading, realised losses on FX hedges are akin to having to accommodate a redemption request without any notice.

When the hedges are rolled at month end, a realised gain or loss is generated on the closed forward FX contract. While FX contracts benefit the investors in hedged currency share classes by preserving their capital in the currency of the share class, there is an impact on the value of the FoHF as a whole in base currency terms. A realised gain on a forward FX contract serves as an additional contribution to the FoHF, while a realised loss has the opposite effect. With the dollar appreciating and the forward FX contracts on Euro and Sterling hedged share classes going short on the dollar, the resultant realised losses have also served to exacerbate dollar based FoHF' liquidity difficulties.

Appreciation of the USD

From August 2008 to February 2009, the Euro and Pound both depreciated significantly against the dollar. The Euro then experienced a second period of sharp depreciation starting in November 2009.

Movements have been volatile, particularly in the EUR/USD trade. For instance, in October 2008, the dollar appreciated nearly 10% against the Euro and 9% against Sterling; December 2008 showed a 10% depreciation against Euro but a 5% appreciation against Sterling; and January 2009 saw the dollar appreciate more than 8% against the Euro.

Consider a US$1 billon FoHF with 30% of assets attributed to Euro-hedged class shares and another 30% to Sterling hedged class shares. In October 2008, the dollar appreciated 10% against the Euro and 9% against Sterling. US$57m would need to be found to cover the losses. (US$300m * 10%) plus (US$300m * 9%). If a FoHF is fully invested or already overdrawn, that US$57m would be financed from borrowings until hedge fund assets on the portfolio could be sold and redemption proceeds received.

Actions in response

Because of the squeeze that hedged currency classes have been exerting on liquidity requirements, FoHF managers have been analysing alternative means of managing these classes. While the management of hedged currency classes in more benign market conditions has perhaps been seen as somewhat of a mechanical exercise, the current economic climate has witnessed the consideration of alternative approaches.

Pound Sterling - United States Dollar

Euro - United States Dollar

One alternative has been to stagger the settlement date of the forward FX contract. Rather than rolling 100% of the hedged currency shares classes' base currency exposure one month forward, the settlement dates are extended for a portion of the exposure. For example, three separate FX forwards could be executed, with 40% of the exposure due to settle in 30 days, 30% in 60 days and 30% in 90 days. While processing the FX contracts over a longer settlement period won't reduce the potential to realise losses, they afford the manager more time to manage the cash flows.

Capping the potential loss is also a possibility. As outlined earlier, a sharp rise in the strength of the base currency relative to the hedged currency can generate a significant loss that will require funding. Derivatives can be used to minimise any potential loss. Consider a currency put option (the right to sell a particular currency at a specified price within a specified period of time) with a maturity date set to coincide with the settlement date of the forward FX contract. If the exchange rate movement exceeds the specified "strike" price of the option, the option will produce a profit that will offset any further appreciation in the base currency, capping the potential funding requirement that may result from a forward FX loss.

However, the use of a currency option may have an impact on the performance return of the hedged share class relative to the base currency class. Because these options must be purchased, the amount of the purchase price causes the performance of the hedged currency share class to diverge from that of the base currency. However, if the exchange rate moves enough for the option to be "in-the-money," further appreciation in the base currency against that of the hedged currency class is essentially unhedged, and would be a gain to the class instead of neutral.

In any case, depreciation of the base currency, the risk investors in hedged currency share classes seek to avoid through their investment in hedged share classes, will continue to generate realised profits on the FX contracts and impact positively on the liquidity of the FoHF. Should we enter a period of US dollar depreciation, FoHF will therefore benefit from currency fluctuations.

The future

While the recent market and exchange rate fluctuations have presented additional challenges to the FoHF managers who offer them, hedged currency classes are here to stay. Attracting additional investment will always be a priority, and such classes do open the FoHF to a wider investor base. Yet as a result of the recent market turmoil, FoHF managers are counting the costs of managing these classes. The impact these classes can have on the liquidity position of the FoHF has forced investment managers to question and review the way they manage these classes. The process, which certainly could not be described as a mechanical exercise, will continue to require greater attention.