As safe havens for investing stagnate, more investors are turning to emerging markets to find growth opportunities.
However, with the history of volatility in currency fluctuations in many key growth areas, such as Latin America and South East Asia, General Partners (GPs) are being increasingly pushed to think beyond dollarized share classes to mitigate currency risk. This is a particular concern for long-hold funds among Limited Partners (LPs or institutional investors).
The challenge for firms is that currency risk has long been a blind spot for hedge funds, with many considering the management of currency risk is too expensive and time consuming. However, with distressed market conditions showing no signs of abating, funds looking to attract international investors, hedge currency risk and diversify their exposure are having to embrace foreign share classes to manage risk adjusted returns in an increasingly competitive market.
Here we explore what foreign share classes are, how they work and how you can integrate them into your strategy.
What is a foreign share class?
When it comes to creating a fund, the simplest and fastest way to issue equity stakes is offering shares in the funds base currency. And in a market where currency levels are stable, this can be sufficient to attract investment and guarantee returns. In a more volatile market, however, firms need to expand their approach – enter the foreign share class.
A foreign share class represents an equity stake in a company or investment fund, denominated in a currency different from the entity's base currency, often the currency of the market in which the fund is being created.
The goal of a foreign share class is to mitigate the impact of exchange rate fluctuations between the fund’s base currency and the LPs preferred currency of exposure.
How Foreign Share Classes Differ from Domestic Share Classes?
Foreign share classes add flexibility, but also complexity when compared with domestic share classes due to:
Denomination: For funds investing outside of their domestic market, or looking to attract investors from abroad, the currency will be matched either to the investment market, or the target investors, rather than the domestic currency of the fund.
Risk Exposure: Foreign shares can lead to higher returns if the hedging currency’s interest rate is higher than the base currency’s interest rate, or vice versa should rates move in the opposite direction.
Regulatory complexity: Foreign share classes are subject to the local regulatory and tax implications based on the currency and investor's jurisdiction.
Why do investors choose a foreign share class?
Demand for foreign share classes is primarily investor led, due to the advantages they present for them, even while they add complexity for GPs:
Reducing currency exposure: In situations where alternative markets present greater opportunities for returns, investors will often look beyond their local markets. However, exposure to the gains of foreign currencies also exposes them to losses, or reduced returns, should valuations change.
Reduced complexity: Currency hedging is complex and time consuming – by having the GP manage the hedging process through a foreign share class, investors can reduce their administration obligations.
Flexibility: For foreign investors, or those booking to diversify their currency risk exposure, a foreign share class can allow greater flexibility and specificity in share choice.
Funds have several options to hedge currency risk for foreign share classes, including forwards, futures, options and historical rate rolls, and. cross-currency swaps. For example, forwards lock in an exchange rate for a future point in time. Options provide downside protection while allowing upside potential. Historical rate rolls use previous fixed rates to avoid extra collateral costs.
The appropriate instruments depend on the fund’s timeframe and objectives, as well as the technical capabilities and internal resources of the team.
How do I issue a foreign share class?
The process of creating a foreign share class requires more input from GPs than domestic shares once an investor purchases shares of a hedged share class in the hedging currency.
Once the GP receives the investor’s funds, there are two further currency transactions to consider:
Converting the investor’s funds from the hedging currency into the fund’s base currency. This is then used to purchase assets for the fund at the spot foreign exchange rate.
Hedging the investor’s currency exposure through a currency forward or options contract. Only the value of the hedged share class is hedged, which means there will be no impact on the returns of the broader fund.
The managing party of the fund will renew or “roll-over” the currency hedge on at least a monthly basis, This updates it to reflect the current value of the underlying assets. In periods of market volatility and when required by regulation, this may happen on a more regular basis.
When the time comes to redeem shares in the fund, the base currency of the fund will be converted into the hedged currency, in line with the hedging strategy.
What are the risks and benefits of using a foreign share class?
A foreign share class is one of the many tools available for firms to hedge their exposure and manage returns in long-hold funds. In all cases, the use of foreign share classes should be weighed with the cost and administrative burden involved.
Risks of using foreign share classes
Foreign exposure: Depending on the volatility in currency exchange rates, these can impact the value of investments when converted back to the fund's base currency. This requires greater attention from GPs to mitigate the potential negative impact and maximize the benefits.
Operational and regulatory complexity: Managing compliance with different regulatory requirements across various jurisdictions requires greater expertise and research from GPs, as well as the tools and resources to manage the operational burden in managing multi-currency investments, including accounting and reporting requirements.
Benefits of using foreign share classes
Widening the pool of potential investors: Foreign share classes can appeal to a broader range of international investors, diversifying the investor base, as well as domestic investors looking to guard against market risk.
Mitigating currency risk: Foreign shares offer natural hedging opportunities against currency fluctuations, a service increasingly demanded by LPs looking to protect their returns.
What are the costs involved in creating a foreign share class?
Given the administration involved, the complexity of managing hedging instruments and the supply and demand pricing of contracts, foreign share classes bring additional costs to factor into a funds pricing strategy:
Legal and compliance: Expenses related to legal structuring and regulatory compliance, including local document submission, tax management and audit.
Currency conversion and hedging: Costs associated with managing currency risk and conversion, including conversion costs from banks, transaction fees and premiums for buying currency forwards, futures, or options.
Administrative and operational: Increased expenses in managing multi-currency operations and reporting, including tracking performance across multiple currencies, personnel costs and regular review.
How can technology enhance the value of foreign share classes
With escalating demand for hedged share classes from LPs, volatile markets and cheaper hedging costs, GPs have the opportunity to take proactive measures to reduce currency volatility in long-hold funds and widen their pool of potential investors to stand out in the market.
Offering stability and security in investments and establishing GPs as dependable and forward-thinking partners to existing and future LPs requires the right tools and support to deliver a consistent, reliable service.
Specialized providers like Deaglo offer technology and services to continually monitor fund exposure and fine-tune hedging models as currency and market conditions evolve. With enhanced visibility via our platform, we can provide detailed risk analytics, valuations across multiple currencies and tools to easily adjust hedging ratios. This enables the fund to efficiently track performance and make informed decisions to optimize their hedging strategy over the long term.
In our work with leading GPs, we have seen increasing implementation of in-depth scenario modeling to determine the right hedging ratios for class allocations and to reduce risk over long-hold funds.
If you want to find out how foreign share classes could benefit your hedging strategy, why not get in touch?