Share Class Hedging (A little bit of Python)
Its purpose and how it works
Currency-hedged share classes generally aim to hedge exposure to the currencies in which the Portfolio is valued against the currency of the share class concerned and are intended for investors wishing to invest in assets denominated in foreign currencies without bearing the risk. associated exchange rate.
For example, a European investor invested in the Lakers - Global fund and does not wish to be exposed to the additional risk linked to exchange rate fluctuations ("FX") between the currency in which the funds are denominated (USD) and the currency in which it trades (CHF) may invest in a share class hedged in Swiss Franc, so that the investor's exposure is limited exclusively to the intrinsic performance of his holdings in USD.
In practice, the share class hedging process (as described below) is not perfect and it only seeks to reduce without claiming to eliminate the impact of exchange rate fluctuations between the currencies in which the asset is valued. Funds and the hedging currency of the relevant share class.
There is therefore no assurance that the currency hedging is 100% effective, and a hedged portion may still carry a certain level of currency risk.
It should also be noted that the volatility of the underlying asset class may increase the extent of imperfect hedging and that significant fluctuations in the underlying asset class may result in a loss or an excess coverage of the hedged part, which may also have an impact on the expected returns.
Finally, although they should normally be relatively small, the transaction costs associated with the hedging process will further reduce the performance of the share class.
Share class hedged in currency use forward exchange contracts to hedge exposure to the currency in which the Funds is valued against the currency of the share class concerned.
Below is a general summary of the hedging process:
Shares subscribed for in a hedged share are converted into the base currency of the Funds at the spot exchange rate.
Forward exchange contracts are used to hedge exposure to the currency in which the Funds is exposed against the currency of the share class concerned.
Profits or losses on forward exchange contracts are recognized as part of the daily calculation of the net asset value of the share class. Forward exchange contracts are generally renewed on a monthly basis, or even less or more.
At each renewal, all capital profits or losses associated with the hedging transaction will be realized. As mentioned above, the capital profits or losses associated with forward currency contracts will only be available to invest in the underlying portfolio assets on each renewal date and this may therefore impact the expected returns.
Reminder of the regulations
This part will give a brief reminder of the regulations concerning class coverage.
The rules governing share class hedging are based on an opinion issued by ESMA (European Securities and Markets Authority) dated January 30, 2017, on UCITS share classes. In other words, this rule is not exclusively dedicated to “share class hedging" but rather all aspects of fund classes. ESMA thinks that the following principles should be followed when defining the different classes of units:
- “Common investment objective”: Share classes of the same fund should have a common investment objective reflected by a common pool of assets;
- “Non-contagion”: UCITS management companies should implement appropriate procedures to minimize the risk that features that are specific to one share class could have a potentially adverse impact on other share classes of the same fund;
- “Pre-determination”: All features of the share class should be pre-determined before it is set up.
- “Transparency”: Differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes.
In our case, we will focus more on the point of non-contagion.
The classes which are defined by a specific derivative hedge to systematically hedge the currency risk allow an investment manager to better align the characteristics of the common pool of assets with the preferences of a class of investors so that they can be seen as an appropriate and proportionate solution to the need to provide effective levels of personalization to investors. However, these derivative hedges could also put investors at a disadvantage in other share classes.
In general, the use of derivatives means that the fund enters into derivative contracts which may generate fund-level payment/delivery obligations that it should be able to meet (e.g. in the event of a cash settlement of forward exchange contracts). Due to the lack of segregation of assets between share classes, the derivatives used to hedge a given class are part of the common pool of assets.
The application of derivative hedging in a class hedged against currency risk introduces a potential counterparty and operational risk for all investors in the fund.
This could pose a risk of contagion (also known as "spill-over") to other classes, some of which may not have derivative cover in place. The risk of contagion could disadvantage investors in those classes that do not have a hedging system, as well as those who participate in the class that benefits from the hedging.
While this risk of contagion can be mitigated, it cannot be completely eliminated. This is because of the possibility that an adverse event will materialize, e.g. by the default of a derivative counterparty or by losses related to assets specific to a class exceeding the value of the respective class.
ESMA therefore considers that any additional risk introduced into the fund by the use of derivative hedging for a given class must be mitigated and appropriately monitored and will only be borne by investors of the respective class within the framework of of its realization.
While the introduction of additional risk through the use of derivatives for hedging purposes at the class level results in increased administrative costs due to the need for risk management, ESMA believes that these costs should only be attributed to the respective class. ESMA is further of the opinion that the must ensure that the profits and losses (realized and unrealized) of the derivative (s) used for hedging purposes only apply to the respective classes.
To ensure that the derivative hedge that is used to hedge currency risk does not result in contagion risk, it is important that the hedge is sized and managed appropriately following a set of minimum operational requirements. With this in mind, ESMA takes the view that the following operational principles should be observed:
A - The notional amount of said derivative must not lead to a payment or delivery obligation of a value greater than that of the class. For this, the potential maximum amount of cash that could be paid to the counterparty or as collateral that could be deposited with the counterparty of the derivative must be assessed with caution by the management company and must not exceed the maximum pool of liquidities and an eligible guarantee corresponding to the value of the class;
B. The UCITS management company must put in place a level of accounting separation which, at a minimum, guarantees that there is an identification of the values of assets and liabilities as well as of the profits and losses (realized and unrealized) in the respective classes on an ongoing basis, and, at least, at the same fund valuation frequency;
C. The UCITS management company must set up stress tests to quantify the impact of losses on all categories of investors in a fund which are due to losses linked to specific assets of a class that exceed the value of the respective class; and
D. Derivative hedging must be implemented according to a detailed and predefined scheme and a transparent hedging strategy.
ESMA is aware that daily subscriptions and redemptions lead to conditions where it is difficult to achieve perfect hedging within a fund or class.
To ensure, however, that the above operational principles are respected, the UCITS management company should, at class level with derivative hedging:
Ensure that the exposure to any counterparty of a derivative transaction complies with the limits set in Article 52 of the UCITS directive about the value of the assets of the class;
Ensure that over-hedged positions do not exceed 105% of the net asset value of the class;
Ensure that under-hedged positions are not less than 95% share of equity inventory of the class to be hedged against currency risk;
Keep the hedged positions under review regularly, at least at the same fund valuation frequency, to ensure that the positions do not exceed or are not lower than the permitted levels indicated above;
Incorporate a procedure in said review to rebalance the level of the hedge regularly to ensure that any open position remains within the levels allowed above and is not carried over from month to month.
ESMA is of the opinion that the operational principles described above should be considered as the minimum standards for classes with derivative hedging.
Concrete examples
Take for example, a fund denominated in USD and which has several classes including 3 "hedged" - class I (CHF), J (EUR) and M (JPY).
Case 1: A subscription or redemption of less than 1% falls on class I.
On 23/08/2021, class I receives a subscription announcement in the amount of 10 units, i.e. 2,000 CHF (0.80%) on trade date 08/24/2021 and value date 08/26/2021. The NAV is 250,000 CHF. As the S / R is less than 1% it is only necessary that the spot change.
To do this, take the value per share (NAV per share), from the NAV on 08/24, i.e. 210 CHF/shares and then calculate the new value of the subscription:
S/R Executed = Qtity Subscribed × 𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠h𝑎𝑟𝑒𝑠 = 10 × 210 = 2,100 𝐶𝐻𝐹
Consequently, the FX spot corresponds to the amount of the S / R calculated, i.e. 2,100 CHF.
Conclusion:
We must therefore sell 2,100 CHF against USD on the value date D + 2, thus 26/08.
Note: As a reminder, the value date of the FX spot must be the same as that of the S / R (Subscription-> 26/08 = spot -> 26/08) to avoid potential breaches.
Case 2: A subscription or redemption greater than 1% falls on class J.
On 08/24/2021, class J receives a subscription announcement in a quantity of 80 units, i.e. 20,000 EUR (0.80%) and a subscription in the amount of EUR 30,000 (1.2%) on trade date 08/25/2021 and value date 08/27/2021. The NAV is 2,500,000 EUR.
The total of S / R is more than 1%, a spot exchange and a forward exchange are therefore carried out.
To do this, take the value per share (NAV per share), from the NAV on 08/26, i.e. 255 EUR /shares and then calculate the new value of the subscription in quantity but this time it will be necessary to add to the result the subscription in amount.
S/R Exc = (Qtity Subscribed × 𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠h𝑎𝑟𝑒𝑠) + S/R in amount = (80 × 255) + 30,000 = 20,400 + 30,000 = 50,400 𝐸𝑈𝑅
The FX spot will therefore be a sell of 50,400 EUR against USD.
On the other hand, we cannot take the same amount for the forward leg because we have to take into account the difference in current coverage.
Suppose the current hedging position is 2,510,000 EUR on 08/31/2021 and the NAV is 2,450,000 EUR, the calculation of the forward leg is done as follows:
Leg2 = (Pos.Act.Cov – NAV) - S/R Exec
Leg2= (2,510,000 – 2,450,000 ) - 50,400
Leg2= 9,600 EUR
Coverage ratio = 2,510,000 /2,450,000 = 1.0244 i.e. 102.44% -> Overcover
The forward adjustment will therefore be of EUR 9,600. (sale of EUR against USD)
Note: The system could automatically adjust the coverage of classes I and M as class J is adjusted. (Principle of synchronization) to avoid a difference in performance between classes.
Conclusion:
We must therefore sell 50,400 EUR against USD on the value date D + 2, therefore 27/08, and forward 9,600 EUR against USD on 31/08.
Case 3: No S / R falls on class M but the coverage ratio triggers the threshold of the authorized range of coverage gap.
On 08/24/2021, class M receives an announcement with no S / R in trade date 08/25/2021 and value date 08/27/2021. The NAV is JPY 35,000,000 and its current coverage is JPY 32,500,000.
The ratio is 0.9286 or 92.86%, so it exceeds the authorized under coverage threshold which is set at 96%.
Therefore, it is absolutely necessary to adjust the cover.
Leg2 = (Pos.Act.Cov – NAV) - S/R Exec
Leg2= (32,250,000 – 35,000,000 ) - 0
Leg2= -2,750,000 JPY
Conclusion:
So you have to purchase 2,750,000 JPY against USD on 08/31.
Case 4: Rolls of share classes without S / R to be processed on the same day (classic case of rolls).
On 08/27, or 2 working days before the FX deadline expires. It is therefore necessary to "roll" the coverage of 3 classes.
To do this, you just need to close the current hedge position on 08/31 and open with the amount equivalent to the last known NAV on 08/27 with term on 09/30.
Conclusion:
Must, therefore :
Sell spot CHF against USD on 08/31 and buy forward CHF against USD on 09/30.
Sell EUR against USD on 08/31 and buy EUR against USD on 09/30.
Sell JPY against USD on 08/31 and buy JPY against USD on 09/30.
Performance calculation
Take as an example, a fund in USD and which has a class hedged in EUR. (The data is real except that the name of the classes is not indicated.) Below, the evolution of the NAV from the end of 2018 to June 2021. We can see at first glance that the curves follow the same trend.
