Market volatility and poor performance have been well documented challenges to mutual and hedge funds, particularly over the past five years. These challenges, whilst monumental, are not the only ones facing fund managers. Another, equally pertinent challenge, specifically relative to funds whose investors are globally distributed, has been currency volatility. For example, during Q1 2012, the US dollar depreciated broadly against most currencies (similarly to other periods of fluctuation such as Q4 2008 and Q1 2009). Such depreciation reflected a number of factors such as policy actions by global central banks and improved investor perceptions on global growth outlook. However, later in Q1 2012, the US dollar began to appreciate, which in part reflected improvements to the outlook of the US economy.
From the perspective of, for instance, euro, GB pound or yen investors (or potential investors) in US dollar base currency funds, the risks arising from such foreign exchange (forex) volatility may be so unpalatable as to dissuade investment. It is in this scenario that hedged currency classes come to the fore. Hedged currency classes are one of the most effective mechanisms available to a fund manager seeking to minimize and mitigate forex risks where the base currency of the fund differs from the currencies in which the fund receives subscriptions.
History, mechanics & structure
Hedged currency classes have traditionally been popular with European funds aiming to attract European investors to invest in funds of hedge funds (which are usually managed in US dollars with the primary investment objective of accruing US dollar-based returns in the long run).
The hedged currency class aims to produce a return which is as closely correlated as possible to the return of the base currency class, thereby minimizing the effect of fluctuations in forex rates. The mechanism usually employed to hedge currency classes is the forward forex contract, being a contract under which currencies are exchanged at a designated time in the future at a price agreed between the parties now. An alternative hedging mechanism (although less well used) is a forex option, which sets the rate at which a fund may choose to exchange currencies. As most funds have monthly dealing cycles, in order to track these cycles, usually the forward forex contracts are rolled each month such that the existing forward contract closes out at the end of the month and a new forward contract is executed with the settlement date set at the end of the upcoming month. Subscriptions and redemptions in respect of the hedged currency class are accounted for in the same period. At subscription a spot deal is executed converting the subscription amount (in a non-base currency) to the base currency equivalent and then sold forward. At redemption, the inverse occurs. Any profit and losses arising from such forward forex contracts (and also any costs incurred in respect of such contracts) are allocated entirely to the relevant hedged currency classes.
Currency class hedging can be created so as to mesh with the existing fund structure. Should a fund adopt an umbrella structure, the currency hedging would be achieved by the launch of a new currency-hedged sub-fund, or sub-funds in the event of multiple currency sub-funds, so as mirror the (non-hedged) currency sub-funds. Alternatively, should the fund take the form of a stand-alone corporate structure then hedged currency classes would be created by means of the creation of new hedged currency share classes. The existence of hedged and non-hedged sub-funds or share classes provides investors with greater choice, for instance an investor may choose between (i) a hedged currency class mitigating the forex risks but the costs of the hedging mechanics will negatively impact returns (for a more risk-averse investor); or (ii) a non-hedged option (for the investor with a greater risk appetite or who is of the view that any relevant forex fluctuations would be in their favour) where the investor will themselves assume the forex risk but in the knowledge that the lack of hedging mechanics and associated costs may lead to greater investment returns.
When setting up the structure of the currency class hedging, consideration should be given to any practical issues that may arise from the use of the financial instrument(s) to achieve hedging. For example, where a fund utilises forward contracts for hedging purposes and if a loss is made on that existing forward contract on settlement date, the fund cannot roll automatically into the next forward contract without using other available funds to purchase the new forward contract. This is because the funds available from the last concluded forward contract would be insufficient to meet thepayment for the following contract. If the fund does not have sufficient liquid assets or cash, it may take time for the fund to realise or liquidate other assets in order to have sufficient cash to purchase the new forward contract. One possible way to address this issue would be for the fund to maintain sufficient cash reserves. However, the downside of allocating such a cash reserve is that, if the reserve is not utilised to purchase new forward contracts, then this cash will remain un-invested.
Implications of hedged classes on fund documentation
Where a fund has created a hedged class, the offering document of the fund would normally include a brief description of the types of financial instruments (derivatives) which the fund proposes to utilize to achieve the hedging. Such a description would normally be contained in the principal features or investment approach section of the offering document.
Whilst hedged currency classes can offer investors comfort that forex risks are minimized, it should be noted that it is virtually impossible for a perfectly hedged currency class to be created due to the difficulty in matching the net asset value of the underlying assets in the hedged currency class with the forward forex contract. Further, factors such as transaction costs could mean that the performance of a hedged class may not be able to match closely with the performance of the base currency class. Therefore, whilst the use of hedged currency classes aims to mitigate and minimize forex risks, the use of this mechanism cannot entirely eliminate such risks.
It should also be noted that the use of the hedged currency class would mean that investors who invested only in the hedged currency class would not be able to benefit from any gains which may arise from currency fluctuations.
Funds with hedged classes should therefore include the points raised above and other relevant risk factors in the funds’ offering documents, drawing investors’ attention to the risks associated with investing in hedged currency classes.
The constitutional documents of a fund are also of great importance and should be drafted so as to ensure that the provisions contained therein sufficiently cover the different issues the fund may face in the context of hedged classes. For example, where a fund has shares denominated in different currencies and all of which are invested in the same underlying pool of assets (whether any or all of such share classes are hedged currency share classes or not), one aspect such a fund should take note of is whether its articles of association take into account the effect currency fluctuations have on the net asset value per share of the fund. This is an issue because whilst all of the shares denominated in one particular currency would have the same net asset value, shares denominated in other currencies would have different net asset value as compared against the other class of shares due to the fluctuations in exchange rates as well as hedging costs attributable to shares denominated in the relevant currencies where such class is a hedged currency share class. On a winding-up or liquidation, the liquidator would not have any basis upon which to distribute the surplus assets to the investors if the articles of association of the fund do not contain provisions relating to this issue. To address this, the articles of association of the fund may be drafted so as to include provisions relating to the set-up of proportion accounts for each class of shares in the fund, such proportion accounts to be maintained in the currency denomination of the shares in the relevant class and adjusted to reflect certain transactions, including without limitation, subscriptions and redemptions. It should be noted that such proportion accounts are maintained for the purposes of calculating proportions only and do not represent debts from the fund to investors or vice versa.
In view of the foregoing, ifa fund wishes to introduce a hedged share currency class, the offering documents and constitutional documents of a fund should be carefully considered to ensure that such documents address all potential issues a fund may face.
Competition between funds to attract large investors nowadays is intense and, in view of the current fluctuations in the exchange rates, the use of hedged currency classes may provide a fund with an edge over its competitors if the potential investor is seeking some protection against the volatility in exchange rates. Therefore, we may see an increase in the number of funds looking to introduce hedged currency classes in their fund structures, particularly in light of the probability of the current forex volatility continuing in the future.
Jeffrey Kirk is a partner at Appleby Hong Kong. He is the Global Head of the Appleby Islamic Finance practise group and the Hong Kong Team Leader of the Banking and Asset Finance Team within the Corporate & Commercial department. Tiffany Chan is an Associate in the Hong Kong office. She joined the firm in 2006 and now practises in the areas of funds and investment services, corporate finance and capital markets.