Why Currency Hedging inside an Equity Fund isn’t such a great idea.

Why would you want to do it?

Equities are like tangible assets. They are not worth any less when the currency in which they are quoted goes down. If the currency goes to zero, equities will go to infinity. Look at the Venezuelan currency. Over the last few years the Venezuelan currency has been collapsing, yet its stock market has been the best performing in the world.

Let’s look at it another way. XYZ Company Limited sells chocolate bars. It buys the raw materials for 100 and it aims to sell at a 30% margin, so its profit is 30. Investors value that profit at 10X earnings. That means its share price is 300. Now imaging that due to a political change people lose confidence in the currency. Over a few years the currency loses half its value. As always happens in such situations, wages and prices rise to reflect the currency devaluation.

So now XYZ Company Limited is still selling the same number of chocolate bars, but it is now paying 200 for the raw materials, and maintaining its 30% margin. This means it is making 60 in profit. Since the company is still valued a 10X earnings, the new share price is 600.

Without hedging you have doubled your money on the shares and halved your money on the currency. In other words, your investment is worth the same. This is normal. The company is selling the same number of chocolate bars as before, at the same margin. It’s not worth any more or less than before. It’s the same company. The value just seems to be worth more, or less, depending on which currency you measure it in.

Consider the alternative. You decide to hedge the currency risk. At first sight, it looks like hedging would have been a good idea. You would have kept all the profit on the shares, AND avoided the loss on the currency. But wait. There are two catches. Firstly the currency may have risen instead of fallen. In that case you would have made a loss on the currency hedge. Secondly, hedging costs money. Markets are very efficient. It is likely that the cost of hedging a rapidly depreciating currency would be close (and probably slightly exceed) the actual depreciation of the currency. So all you would have done is replace the currency loss by a similar hedging cost. More tangibly. You are taking a bet on the currency, when you are supposed to be betting on the value of the company.

Currency Hedging is not Risk Free

As mentioned in the previous paragraph, the minute you start hedging the currency, you are taking on currency risk. The currency may move by more than expected, or it may move in the wrong direction. The performance of your fund can end up being swung around more by the currency movements than by the share price movements.

In an extreme example, a currency hedge could wipe out 100% of the value of your fund. It’s not likely to happen, but its possible. However an extreme currency move could cause a serious loss.

Let’s take an example. A UK fund priced in £ sterling owns $200 of an American stock priced in $. The exchange rate is £1 = $2. So the price of the fund is £100

The fund manger decides to sell $200 forward for GBP 100. The next day the pound has a Brexit moment and plunges. At the same time America has fantastic economic news and the dollar soars. The value of the pound halves to 1:1 against the dollar. The fund manager now has a loss on the hedge, so he receives a margin call from his bank. The margin call is equal to the loss so far, I.e. $100. The only way he can meet that margin call is to sell his American stock. Unfortunately due to the soaring dollar, overseas sales have become more difficult for American companies. The share price has halved. His $200 share is now only worth $100. He sells the shares for $100 and pays the margin call of $100. His fund no longer has any assets (Value=zero), but still has ongoing risk due the forward forex trade. Due to the absence of collateral, the bank forces the fund manager to close the forward forex trade crystallising the loss. Investors have seen their £100 investment go to zero, whereas if there had been no hedging it would still be worth £100.

Chart of GBP/USD exchange Rate

Currency hedging is complicated, time-consuming and costly

It goes without saying that you have to know what you are doing before engaging in currency hedging, It takes a very smart and nimble brain with years of practice in the forex markets to get it right.

You have to be on the ball and checking the currency every day. Share prices change and the fund size can change due to subscriptions or redemptions all the time. The amount to be hedged may need to be adjusted. That means daily work and monitoring. It’s time consuming.

Costs are another factor. Everyone knows that the forward rates are a function of the interest rate differential between the two currencies. That can mean you get a better or worse rate than the spot rate. You pay or receive what are known as the “forward pips”. So far so good. However, you may not have realised that the “forward pips” are different depending whether you are buyer of seller. They are not the same, just as interest rates are different for lenders compared to borrowers. That’s a cost.

In addition, each time you buy, sell, or roll a currency forward there will be a bid-ask on the currency itself. The difference may be small but it soon adds up if you do it 4 times a year. You bank may tell you that they can do it for you automatically. They may tell you that it will only cost you 30 pips, 50 pips of 90 pips all-in a year. That’s only half the truth. When the bank says it will only cost you 50pips, they are talking about the profit the bank expects to make. It costs you more than that, because the market has two prices for everything, bid and ask prices. The bank may get you the best bid or ask and add its spread for the forward pips of 5 or 10 pips, but there will still be another 5 or 10 pips spread hidden in the bid-ask for the forward pips. For a little extra the bank might even offer you “dynamic hedging” where the size of the hedge is adjusted daily to match the ever changing values.

When you add up all the costs and spreads of a hedging strategy it is likely to be costing you close to 1% if you roll 4 times a year. That’s a big drain on your fund performance. I’ve seen the currency hedged versions of a bond fund underperform the non-hedged version of the same fund, by more than 2% a year. Even thought the exchange rate ended back where it started.

Summary

There’s no point in hedging the currency of a share just because it is quoted in a foreign currency. The same company might also be quoted on domestic exchange in domestic currency. The price should be the same on both exchanges. Yet you would hedge the shares quoted overseas, but not the same ones quoted domestically? Where’s the logic in that? There’s no point in currency hedging.

Currency hedging is not risk free. Why would you want to take that risk?

Currency hedging eats into your performance, no matter which way the currency goes. Why under-perform?

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