Share class hedging may not offer best in class hedging | Insight Investment

Currency-hedged share classes are often inefficient

There are three angles to this issue:

1. Hedged share classes often only hedge the US dollar (USD) risk in the portfolio and leave other, smaller currency risks unmanaged. This leaves investors with a residual currency risk that can be significant, depending on the allocation of assets and the volatility of the unmanaged currency component.
2. If investors hold several funds with international asset exposures, holding numerous hedged share classes can lead to implementation inefficiencies and higher transaction costs, as the investors would not benefit from any netting across different currency exposure positions. This is a particular issue if the assets in the various funds have a low, or negative, correlation.
3. Currency risk is typically managed using derivatives, such as FX forwards, which require periodic funding of profits and losses at regular settlement intervals. An equity manager would need to maintain a cash buffer to meet any losses that arise, which leads to a structural reduction in exposure to the underlying equity index. This has two direct implications: firstly, cashflows or collateral requirements managed at the individual investment level are not optimal and create additional drag; secondly, the fund manager of the hedged share class would be consistently under-investing in the underlying asset in order to maintain appropriate cash buffers for the FX hedges.

In our view, a significant benefit of using a dedicated currency manager is that they can be responsible for managing all currency risk at the overall portfolio level, after working out the net currency exposures from the full underlying list of international asset exposures. This type of approach should be expected to lead to more comprehensive and efficient currency hedging as well as more efficient management of the collateral pool.