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

Share-class hedging comes of age

Securities and Fund Services

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WGBI Non-EUR WGBI Non-GBP

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100% hedged into EUR Unhedged EUR 100% hedged into GBP Unhedged GBP

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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 multiplyAs 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

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 hedgingOne 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 redemptionsFunds 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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For more information, please contact:

Cathal O’Daly EMEA Client and Sales ManagementIreland+353 (1) 622 6260 cathal.joseph.odaly@citi.com

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Citi OpenInvestorSM is the investment services solution for today’s diversified investor, combining specialised expertise, comprehensive capabilities and the power of Citi’s global network to help clients meet their performance objectives across asset classes, strategies and geographies. With an on-theground presence in over 95 countries and over USD13.5 trillion in assets under custody, Citi offers award-winning service and unmatched scale.

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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 hedgingCiti 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 share-class 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 optionsThe retro-rate model for subscriptions and redemptions is just one example of the different execution options Citi has

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.

PerformanceUltimately, 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.

Liquidity, flexibility, high-quality reportingThere 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.