Investing across different currencies introduces currency risk to an investment, where a mismatch in the currency of a fund and its underlying investments expose the fund to fluctuations in exchange rates.
Currency hedging is a technique used by investment managers to minimise the impact of currency fluctuation on an investment. A hedge is not intended to make money, simply protect against losses.
An investment manager will hedge the risk of exchange rate fluctuations by entering into derivative contracts, such as the following example, a foreign currency forward.
A fund manager has a fund denominated in Sterling but purchases an asset in US Dollar. If left unhedged, the fluctuation of exchange rates will affect the value of that asset in the portfolio.US Dollar Asset Current Exchange Rate GBP Value in Fund
USD $100.00 x 1.6 = GBP £62.50
If the exchange rate rises to 1.7, the GBP value in fund reduces to GBP £58.82.
If the exchange rate falls to 1.5, the GBP value in fund rises to £66.66.
The fund manager enters into a foreign currency forward, a type of derivative, and locks in the future exchange rate in three months to 1.6.
If the exchange rate rises during this period to 1.9, the GBP value in fund will remain at £62.50, whereas unhedged the value would drop to £52.63. This would have resulted in a loss of £9.87.
If the exchange rate falls during this period to 1.4, the GBP value in the fund will remain at £62.50, whereas unhedged the value would have risen to £71.43. This would have resulted in a gain of £8.93.
The effects of exchange rate fluctuations have been neutralised in the fund. There is a cost for entering into the derivative contract, which would need to be considered, however the fund is exposed only to the rise and fall in the price of that asset.
Fund managers may provide hedged or unhedged share classes of their non-base currency denominated funds, so you should check the hedging policy of any fund that you are considering.
Hedged share classes have additional costs compared to unhedged share classes, with the cost of derivatives used for hedging. It is worth noting that hedging is not perfect, so there will always be currency risk of some degree in a fund. It is also worth noting that whilst currency hedging neutralises exchange rate exposure, this means that a hedged share class cannot benefit from these fluctuations. Finally, mistakes in hedging risks can lead to losses that could affect the returns of a fund.