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Aon Retirement and Investment Blog

Interest Rate Divergence and its Impact on the Relative Performance of Currency Hedged Share Classes

For many years since the financial crisis, there has been little difference in short term interest rates across the developed world.  As a result the performance of different currency hedged share classes of funds has been for the most part similar.

As short term interest rates between currencies have begun to diverge over the last 12-18 months, there has naturally been a corresponding deviation in the performance of currency hedged share classes.  This has implications for hedge fund investors seeking to compare the performance of their GBP denominated hedge fund share classes with corresponding hedge fund indices which are usually denominated in USD.  The impact each year of this effect for GBP investors is shown in the chart below:


To understand the reasons for this, it’s important to understand the basic mechanics behind share class hedging.

The Cost Of Share Class Hedging Is Equal To The Interest Rate Differential Between Two Currencies:
 
All funds have a base currency in which they operate, with USD being the most common.  If investors whose assets and liabilities are based in a certain currency want to invest in a fund which has a different base currency to their own, they expose themselves to both investment and foreign exchange risk.  For example: GBP investors investing in a USD denominated fund are exposed to both movements in the GBP/USD exchange rate as well as the performance of the fund.  In order to hedge this USD risk, they would invest in a GBP denominated hedged share class where they invest in GBP and the fund manager undertakes the hedging, usually by purchasing a currency forward for the amount of the investors’ investment.  However this has an associated cost, which is determined by the difference between the interest rates in the two currencies as per the formula for pricing a currency forward:

How Can Clients Easily Account For This Difference?
 
So with the technical part out of the way, what does this mean practically for ensuring fair relative comparison of hedge fund investment returns to hedge fund indices?  Unfortunately HFR calculates only its broad Fund Weighted Composite Index (“HFRI FWC”) in multiple currencies, and not its plethora of sub-category or Fund of Funds indices which are only available in USD.  This means that to accurately compare an investment in a GBP hedged share class of an Equity Long/Short Fund or Fund of Hedge Fund with its appropriate index published in USD requires an extra calculation to account for the interest rate differential over the measurement period.
Fortunately HFR calculates its HFRI FWC currency indices using a similar method to how a manager would hedge a share class, so we can use the differential from the above chart to create a close approximation of any sub-category index return in GBP.  Taking 2017 as an example, GBP investors would need to subtract c. 1.25% from the USD denominated sub-category index to make it comparable with their GBP share class return.
To conclude, interest rates between the US and UK have diverged sufficiently to mean that the performance difference between USD and GBP currency hedged share class returns is now more sizeable.  In order to make a relevant performance comparison, investors should adjust the performance of either their GBP returns or the USD index returns by the short-term interest rate differential.  Investors in other currency hedged share classes, such as EUR, will need to make a similar adjustment.  Given even lower interest rates in EUR, the performance difference at this time is even larger than for GBP, amounting to 2.1% in 2017.

Chris Ullathorne is a senior consultant and hedge fund specialist in Aon Hewitt’s Global Investment Manager research team in London.

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