What is a hedged share class and why are investors asking for them?
Balancing risk and opportunity has always been a key responsibility for both sides of the investment equation, but recent years have seen a shift in focus on the part of investors regarding who should take responsibility. While emerging markets still offer attractive possibilities for both GPs and LPs, currency volatility in long-hold funds continues to be a significant concern for institutional investors, especially as these markets become more uncertain.
As institutional investors grow more risk-conscious, the hedged share class is emerging as a vital solution to navigate these potential changes in the market. Here we examine the evolving role of hedged share classes, the driving forces behind this trend, and the strategies involved in managing the associated risks.
What is a hedged share class?
A hedged share class is a specific category of investment fund shares that employs techniques to mitigate the impact of currency fluctuations on the value of the investments.
By using various hedging strategies such as forward contracts or options, the hedged share class aims to neutralize the currency risk, providing investors with returns that are more closely aligned with the performance of the underlying assets in their local currency.
Why are hedged shares important now?
Currency risk has been traditionally managed by the investors themselves, with General Partners (GPs) often sidelining currency hedging due to time and resource constraints. While some investors still prefer to take on currency risk, either expecting high enough returns or employing their own hedging strategies to mitigate potential downside, an increasing number are putting responsibility back on the GP.
In a market where funds are competing for a smaller pool of institutional capital, the ability to meet these needs is now a key factor in the ability of funds to meet their goals. Investors can now afford to be more discerning when looking at investment vehicles, putting the pressure on GPs to produce better products that fit the risk-profile of their funders.
More Volatile Markets: Investors have become more risk-aware, prompting them to seek stability, particularly in distressed market conditions.
Cheaper Hedging Costs: Costs of hedging are decreasing, in line with the weakening dollar and strong performance of emerging market currencies.
The hedging challenge for funds
By opting for hedged share classes, institutional investors can gain a sense of security for their commitments in emerging markets, insulated from abrupt currency value changes, particularly in the case of close-ended funds.
There is an intuitive appeal to hedging being the responsibility of the GP – after all, they sit in a dominant position, holding more information about the fund strategy, currency impact, cash flow implications and visibility over composition. GPs offering hedged vehicles for long-hold funds might consider implementing an active overlay approach and collaborating with innovative counterparties.
However, this also creates a new realm of activity for funds who have previously steered clear of hedging due to either insufficient expertise or inadequate internal systems. Without the right tools, strategies and experience and experience, hedging risks adding a range of new costs, which can cut into returns for GPs or LPs, including:
Interest rate differential, arising from the difference between the interest rates of the two currencies in a currency pair.
Transaction cost: This cost encompasses the spread charged by financial institutions when executing the hedging trades, linked to the buying and selling prices of the foreign exchange contracts.
Collateral drag: When entering into certain hedging agreements, particularly in the regular derivatives market, managers might be required to post cash collateral to cover potential margin call events on their positions.
In a market where the returns on mature investment markets and emerging markets may come down to a few percentage points, the impact of these costs can quickly bring emerging investments into parity with more stable options. This adds pressure for GPs to not only offer hedged share classes, but to do so at a price and operational overhead that can remain competitive in the market.
The long term future of hedged shares
With more firms competing for fewer investment dollars, GPs will have to do more to distinguish their products and services. Hedged share classes have a key role to play in reassuring institutional investors, reducing risk and building a competitive, LP-focused fund offering. However, competing in this service-oriented market will require GPs to develop new expertise and capabilities within their funds.
Tools such as Deaglo can deliver the data, insight and calculations to create sustainable, competitive strategies that protect returns for investors and managers alike, helping GPs reduce transaction costs, negotiate better prices and credit facilities and create bespoke strategies based on LP risk-appetite.
To find out how hedged shares can make your fund more attractive and stable – request an assessment with our team today.
In case you missed it: LATAM VC and PE funds Leading the Way in Emerging Market FX Hedging.