Currency hedging trend exposes disparity in motives

Currency hedging is becoming common in retail asset management as a way of protecting sterling-based investors from excessive volatility. But with swings in the currency markets becoming more pronounced, disparities are emerging in the way funds use it.

Some managers treat unhedged currency investing as another way of making money, particularly in emerging markets. Others are launching share classes that hedge out the risk of overseas currencies for their investors.

Currency forward contracts are the most frequently used hedging instruments, mainly because they are cheap and easy to trade. Such contracts oblige fund managers to buy or sell a certain amount of foreign currency at a set date and price.

If the net asset value of their underlying equity holdings increases, they have to adjust the currency forward contract to lock in gains. They will also have to adjust the contract every time they make portfolio changes, whether they sell or add stocks.

Asset managers are increasingly introducing hedged currency share classes for investors who want to invest in overseas assets, but without taking a risk on the currencies in which the assets are denominated.

Dalton Strategic Partnership last month introduced a hedged sterling share class on its Melchior Japan Advantage fund. Richard Jones, a partner, says the “questionable” outlook for the yen has driven demand for a share class that removes currency risk. (article continues below)

Likewise, JO Hambro Capital Management introduced a sterling hedged share class to its JOHCM Japan fund in April last year, following demand from investors.

“The relative strength of the yen has become an unmerited obsession on the part of the investment community,” says Ruth Nash, a manager on the fund.

Mike Champion, the head of product development at Schroders, says hedging is also common in fixed income, total return and absolute return mandates. “Most investors look at hedging as a means of reducing risk rather than enhan­cing returns,” Champion adds.

While asset managers are increasingly offering hedged exposure on Japanese funds to guard against falls in the yen, fund groups offer few, if any, hedging options against potential falls in emerging market currencies.

Some equity managers are taking big bets on which currencies will outperform, which has influenced both demand and supply for hedging.

During the planning stages of the UBS Emerging Markets Equity Income fund, UBS Global Asset Management considered offering investors a hedged share class.

The team abandoned the idea when investors showed a preference for unhedged share classes. Investors generally consider emerging markets ­currencies more attractive, although emerging market nations such as Brazil have warned of a currency bubble.

Vincent Lagger, a co-manager of the Julius Baer Chindonesia fund, says “currencies are part of the game when investing in emerging markets”.

Not only is there a lack of demand for hedged emerging market funds, supply is also constrained.

Hedging emerging market currencies, especially the more exotic ones, can be challenging and expensive.

Toby Hogbin, the head of product development at Martin Currie, says higher volatility in emerging market currencies has a key influence on the costs of hedging. Liquidity and sophistication of the underlying market is a second big driver of costs.

In the developed world, however, equity income investors demand dividends in overseas currencies to diversify away from the British market. Global equity income providers such as Sarasin therefore offer investors hedged exposure to overseas currencies to ensure British income investors are not taking any currency risks.

Sarasin offers investors hedged and unhedged access to its Global Equity Income fund as well as its EquiSar Global Thematic fund, for instance.

To date, asset managers have made an effort to meet investors’ demand for hedged share classes. If volatility in the currency markets continues, however, the demand could be more pronounced, and more difficult to meet.