FX Hedging

The FX hedging strategy a fund uses can have a material effect on a fund’s performance but is rarely discussed or considered by investors. The FX hedging strategy is particularly important for funds that have material investments in assets denominated in a currency that is different from the base currency of the fund. 

When we set up the 1OAK MA80 fund, we decided to hedge the FX risk for each share class. This means that the fund’s performance will depend on each asset class’s performance in its local currency. The bulk of the fund’s assets are in USD (S&P, treasuries, TIPS), so the FX hedging strategy has a marginal effect on the performance of the USD share class. but is important for the GBP share class. 

As we discuss below, the decision to hedge FX risk means that the GBP share class has not benefited from the depreciation of GBP versus USD, but on the other hand, it means that the fund’s performance will not be held back when or if GBP increases in value against the greenback. 

The GBP share classes are likely to offer strong relative performance if GBP appreciates. 

When a fund invests in assets denominated in a currency other than the base currency of the share class, the fund’s value is exposed to both the asset’s price and the exchange rate. 

To illustrate the impact of changes in the FX rate, assume that a GBP-denominated fund has a $1m investment in a USD denominated asset. At the time of purchase, the FX rate is £1.00/:$1.20, so the asset is worth £833,333.

If the FX is not hedged, if GBP appreciates the value of USD assets will fall. For example, if the FX rate moves to £1,00/$1.40 (GBP is appreciating because £1 now buys more USD), the value of the $1m asset falls when converted to GBP to £714,286. The fund will have lost money even though the local value of the asset has not changed.

On the other hand, if GBP depreciates, the value of USD assets in GBP will increase. If the FX rate changes to parity, £1.00/$1.00 (GBP depreciated when £1 buys fewer USD). Now $1m of USD assets will be worth £1m. The fund will have made money even though the local value of the asset has not changed.

The decision to hedge or not hedge the FX exposure in a fund is a material decision and investors should know the position that managers take. Most passive funds and ETF’s will either hedge all the FX risk or not hedge at all. Some active funds adopt an active approach where they may hedge some of the risk depending on their view on the likely direction of various FX rates. 

The GBP, USD and SGD MA80 share classes are all fully hedged because this is the strategy that investors wanted. We dont profess to have any insight into the likely future movement of FX rates and so would not offer an active FX hedge share class but could launch unhedged share classes if there is demand. 

As it turns out the strength of the USD and weakness of GBP means that the fund has not been able to offset the effect of decliniung asset values with the depreciation of GBP. 

Through 2022, USD equities and bonds have dropped in value, and GBP has depreciated from a high when £1 bought about $1.35 to $1.85 today, a 13% depreciation. 

Source: 1OAK Capital and Bloomberg 24.11.2022

The S&P has dropped by almost 20% from 4755 to 3844. 

For funds that do not hedge the FX exposure, the decline in the value of GBP against the USD partially offset the fall in US equities, so the fall in value of their US equities would only have declined by about 7.5% in GBP. 

Because the 1OAK fund hedges the FX rate, the fund has absorbed the full effect of the fall in the value of the S&P 500. 

The effect of the FX hedging strategy is magnified because the fund has an overweight exposure to the S&P. BlackRock has maintained a high allocation to US equities, and we have set up the fund, so there is no parochial bias to UK equities. As a result, the fund has a high allocation to US equities and bonds compared to its peer group. 

The chart below shows how the FX hedging strategy the fund uses means the value of the fund has not benefited from the depreciation of GBP. If the GBP share class were unhedged, the fund’s value would have only dropped 2% this year. The hedging strategy the 1OAK MA80 fund uses means that we have not benefited from the depreciation in GBP to offset the fall in the value of international assets.

Source: 1OAK Capital and Bloomberg 24.11.2022

We stand by our decision to offer share classes where we hedge the FX exposure when it invests in assets denominated in currencies other than GBP. We accept that hedging the FX risk has hurt the fund’s returns, but we remain convinced that it is the right strategy:

• We have made it clear to investors that we hedge the FX risk, so investors are fully exposed to the performance of equities and bonds in their local currencies.
• The FX hedging policy and high exposure to USD assets has caused the fund to underperform other multi-asset funds with more GBP asset exposure and thise that hedge some or all the FX risk.
• Unless a manager has some expertise in FX, in our opinion, the only sensible approaches to take are to hedge all FX risk or invest without a hedge. An active hedging approach would imply that the manager has some ability to predict changes in FX rates. 
• Hedging the FX risk means that the performance of each share class will be similar. 
• In our opinion, changes in FX rates are completely unpredictable. In the medium term, hedging this risk will reduce volatility without harming returns.
• We can issue an unhedged share class if there is demand.

The fully hedged GBP, EUR and SGD share classes of the 1OAK MA80 fund will suit investors who

• Expect equities to rise: the fund maintains a high level of exposure ti equities
• Want broad geographic exposure with no parochial bias to the UK
• Anticipate that the local share class will appreciate against the USD; the fund will benefit if the local currency increases in value. Unhedged funds will lose if other currencies depreciate against GBP.