Fund currency denominations and share classes: the role they play in a portfolio

Some asset managers offer funds that have share classes either denominated or hedged to a range of currencies. This article seeks to explain how this works, the benefits and risks of using these funds, and the options available to advisers.

After reading this piece, you will have an improved understanding of currency risk, the options available to combat these conditions and how currency share classes work.

30 minutes of CPD include:

• Article: 20 mins
• Related learning video: 3 mins
• Podcast: 2-12 mins
• Quiz: 5 mins

When investing globally, a risk that many retail investors may overlook is currency risk. This form of risk is ever present, but it is particularly notable in the current environment.

The fallout from the global pandemic, combined with supply chain shortages and the uncertainty caused by war in Ukraine have all contributed to inflation and turbulence in financial markets.

Many of the world’s major central banks have responded to this situation by adopting a tighter monetary policy and raising interest rates – the first time in years in some cases.

Currency markets have become more volatile in turn. For example, the US dollar surged on the back of higher interest rates, reaching multi-year highs against the euro, sterling, and Japanese yen.

As the price of oil has risen, so too has the Canadian dollar, which is highly sensitive to commodity prices, while the Japanese yen has underperformed significantly.

Beyond the day-to-day considerations of equity and bond investors, volatility in the foreign exchange market has provided an unwelcome overlay of risk that some investors may need to factor into their planning.

In this piece, we will examine currency risk and some of the tools investors have at their disposal to help navigate it.

What is currency risk?

When investing in assets from different countries, investors may become exposed to currency risk, or exchange rate risk as it is otherwise known.

This has little to do with the asset itself, but rather the relationship between the currency in which it is denominated, and the currency used to purchase it.

Fluctuations between the two may cause the value of assets to oscillate, with those dynamics controlling the outcome of your investment. In broad terms, should the exchange rate go against the investor’s currency, it is possible that any gains made by the foreign asset may be eroded when converted back.

“You need to be aware of currency,” says Darius McDermott, managing director of FundCalibre. “The S&P 500 may perform well, for example. But if you’ve purchased with the pound, and sterling rises against the dollar – you may not make such a good return yourself.”

That said, currency risk is a two-way relationship, as Darius points out: “Currency movements can also be very beneficial. The inverse reaction, whereby your overseas equities go up and your currency appreciates, can lead to better returns.”

Related learning: Do you need to worry about currency risk in a global equity fund?

Currency risk is an important factor for investors, and one not limited to purchasing assets from overseas markets, as Darius adds: “Approximately 65% to 70% of the FTSE 100 earnings are from overseas. So, if you examine Shell Plc, for instance, most of its earnings are in US dollars. So even with a UK listed stock that’s priced in pounds on the FTSE 100 – it still has currency exposure, because its earnings come from overseas.”

It’s worth noting that bond markets are particularly sensitive to these conditions, says Richard Hodges, manager of the Nomura Global Dynamic Bond fund.

“Historically, currency risk has tended to dominate bond volatility. So effectively a UK investor buying US dollar share classes would end up buying a lot of US dollar risk,” he says. “This is the reason we offer our fund with GBP-hedged share classes to UK clients. It allows clients to experience the returns of the fund without the (vast majority of) the currency risk versus the USD, if they invested in our USD share classes.”

Related learning: Uncle Jim’s World of Bonds: Credit – No Hiding Place in Investment Grade Bonds. IG and HY both -9% this Year (4-6 mins)

Navigating currency risk

To help circumnavigate such concerns, fund managers may hedge their overseas investments to dampen the disparity between the value of two currencies.

This can be achieved through several mechanisms, including forward contracts and options.

For most investors, however, the easiest way to access currency hedging is by investing in a fund via a hedged share class. Many funds will offer a range of share classes, aimed towards different investors, at both a retail and an institutional level.

Currency share classes allow investors to take a view not just on the investment itself, but on the wider trajectory of global currency. Though not a silver bullet to currency risk, these share classes offer relative protection from the price movements between the fund’s base currency and that of the investor.

“Our GBP-hedged share classes are used by the majority of our UK clients,” says Richard. “We do have a very small number of UK clients who use the USD share classes. Our understanding is that these share classes are used by clients who either actively want US dollar exposure, have their own currency hedging arrangements in place, or have underlying clients who are based in the US dollar.”

So, when might a currency hedged share class be appropriate for an investor?

“As an example, let’s suggest that I want to take exposure to Japan but I do not want the currency risk associated with the Japanese yen. To mitigate this, I would buy a hedged share class,” Darius says.

“In recent months, the Japanese yen has been very weak, particularly against the US dollar, because of interest rate differentials. Interest rates are clearly going up in the US, but there has been no sign that Japanese rates will going up at any great speed. That has meant that the dollar has strengthened massively against the yen and, at this moment, if you own Japanese equities in dollar terms, you’ve lost money.”

He adds, “Hedging currency removes that particular risk, but it’s worth noting that it costs to hedge, and at different times in the investment cycle, the cost of hedging can become more expensive.”

How currency hedged share classes work

Each fund management company will have its own view on the most efficient method of hedging.

In some instances, a master portfolio will be used as a framework for each share class, with each individual holding then bought in the share classes’ prescribed currency to create consistency across the range.

Other managers will use that investment framework as a reference point, but instead populate each portfolio with holdings both specific to, and in most cases denominated in, their respective jurisdictions.

The Elite Rated GAM Star Credit Opportunities fund uses the latter option. “We have a similar strategy, but with three distinct funds,” says co-manager Patrick Smouha, “That’s why I think we’re very different from a lot of groups.”

“We have a GAM Star Credit Opportunities fund in sterling, another in euro and one in the US dollar,” Smouha says. “They’re three different funds that employ an analogous strategy, but they do have some differences. For example, we invest mainly in financials, so within the sterling market, you’re going to have more UK names and within the euro class, there may be more of a European bias.”

This approach of offering several distinct funds denominated in different currencies, as opposed to simply offering different currency share classes, offers some benefits.

“Having the different share classes means that when you buy something in euros in the euro share class, you have clearer visibility of what your returns are going to be,” he says.

“For example, where HSBC has bonds in dollars, euros, and sterling, you can see that sometimes it’s right to buy the sterling version in dollar, sometimes it’s right to buy the euro in sterling, but this has to be monitored the entire time (for exchange rate risk). Whereas if you buy the sterling class in sterling, you can see what you’re going to get.”

As with the previous example of Shell PLC, where although the stock is listed in the UK, much of its earnings stem from abroad, despite employing this methodology, a degree of currency risk is still to be expected.

“We have share classes in US dollar, euro and sterling, and they each have maybe 20% to 25% which is outside their currency, but at least you have circa 75% which is within the currency, so you have a lot more visibility about what exactly you’re receiving,” Patrick says. “That’s really been the general idea as to why we have approached hedging this way versus other houses that opt for one master share class and then hedge it all like that.”

When to consider currency hedging

Much like company shares, currency markets (or foreign exchange markets) are susceptible to macroeconomic factors and may fluctuate based on the market condition.

Interest rates and inflation are among the key drivers of currency strength, as are a nation’s debt levels, trading activity and overall economic health.

The question then is, how should investors approach currency hedging and when might a good time to hedge?

“You’re going to be looking at the valuations and what the rate of each currency is versus its longer-term history,” Darius says. “As an example, the pound trades at roughly 1.50 to the dollar. There was a period in the mid-noughties where the pound went to two dollars. That historically was a very good rate for the pound – the pound was strong; the dollar was weak – so that’s a good time to take exposure to the dollar.”

Like any other area of investing, however, the direction of travel can turn based on events outside of the stock market, and investors should be mindful of the impact this may have on their portfolio.

Darius adds: “After Brexit, the pound crashed against the dollar and got as low as 1.10. So, the value of the currency can have a meaningful impact in your long-term returns, whether you’re investing in equities or bonds.”

However, it is worth noting that the costs linked to most hedging systems may preclude some currencies from being hedged, as Richard explains, “Occasionally we identify some emerging market local currency bonds where the local currency yield is an important part of the overall total return of the fund. These currencies can be costly to hedge.”

He continues, “Part of the reason for this is that these currencies often have higher interest rates than those prevalent in the developed world. If you hedge from a high interest rate environment to a lower interest rate environment, the mechanics of currency hedging mean that you pay a cost broadly in line with the differential of those two rates.”

A reminder of the learning objectives

• Understand the meaning of currency risk and its potential impact on an investment portfolio
• Be able to explain how currency share classes work
• Explain how investing via currency share classes may impact returns