The impact of foreign currency on a managed fund
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Scott O'Ryan is Morningstar's data analyst.
Currency hedging is an often overlooked feature of managed funds. It is easy to view hedging as a purely mechanical way in which managers will offset one of the main risks associated with international investment - currency. The rationale for hedging can be understated, but it is a valuable behind-the-scenes player in a portfolio. This article takes a look into how hedging is implemented, as well as some of the issues associated with its use.
Currency hedging provides a means for fund managers to control currency risk in a portfolio. In the simplest sense, pure hedging strips away any foreign currency influence so returns reflect only that of the underlying investment. One of the more common methods of hedging is by entering a currency swap agreement. In this instance, two parties swap a pair of currencies at previously agreed amounts, dates and prices. This type of plain vanilla swap is usually short-dated, with 30, 60, or 90-day expirations typical. As a contract expires, the manager can roll into a new arrangement if they want to maintain the hedge.
When a fund manager implements a currency hedge on their offshore investments, they'll set a "hedge ratio". This ratio represents what proportion of their total offshore currency exposure they'll hedge back to New Zealand dollars (NZD), usually given as a percentage. Forecasting currency movements is notoriously difficult, and as such, some managers allow their longer-term strategic ratios to hover around the 50% level (while giving them the authority to adjust if the need arises). Other managers may take bolder positions on the direction of the currency and have a shorter-term, tactical hedge that reflects their forecasts.
Table 1 below shows a selection of KiwiSaver providers' long-term strategic hedge ratios. As shown, all fund managers in the table fully hedge their exposure to international fixed interest and international property. This is common for all defensive investments, as fund managers wish to remove the full impact of dramatic swings in currency on this portion of the portfolio. However, there is more disparity in the hedging of equities.
Table 1: Strategic (long-term) Hedging Ratios For KiwiSaver Funds Morningstar Qualitatively Assess
|International Fixed |
* AMP calculates its hedging exposure for listed property from an after-tax perspective.