The three costs of a hedged class in a semi-liquid fund, and the cash a currency move demands at the next roll.
A currency-hedged share class costs the interest rate differential between the two currencies, plus dealing costs, plus the drag of the cash it must hold to settle its forwards. For a euro class of an illustrative US dollar semi-liquid fund, with dollar rates 2.00 points above euro rates, that is 2.14 per cent a year: the class returns 6.86 per cent when the fund returns 9.00 per cent in dollars. And an 8 per cent move in the dollar can require a cash settlement of 8.0 per cent of the class's NAV in a single quarter.
Worked in full in The Private Wealth Fundraiser by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Private banks in Europe, the UK and Switzerland sell in their clients' reference currency. A dollar fund that offers only a dollar class asks the client to take a currency position alongside the asset position, and many discretionary mandates and suitability rules will not. So the fundraiser is asked for a hedged class, and needs to answer two questions before agreeing: what it costs the client, and what it does to the fund's liquidity. The first goes into the fee stack the advisor shows the client. The second is the one that gets missed.
| Input | Value |
|---|---|
| Fund return in dollars, after fund-level fees | 9.0% |
| Three-month dollar rate, annualised | 4.25% |
| Three-month euro rate, annualised | 2.25% |
| Forward bid-offer, a year on notional | 0.05% |
| Hedging agent fee, a year on notional | 0.03% |
| Dollar cash held for the class's settlements | 3% |
| Hedged class NAV, euro millions | 200 |
| Whole fund NAV, euro millions equivalent | 500 |
| Fund liquidity sleeve | 10% |
The class hedges 100 per cent of its NAV, cash included, with forwards rolled quarterly. Rates are illustrative, not a forecast.
Carry cost = 1 − (1 + rEUR) / (1 + rUSD)
Buffer drag = buffer × (fund return − rUSD)
Total cost = carry + dealing + agent fee + buffer drag
Settlement cash at a roll = hedged notional × adverse currency move
In Excel: =1-(1+B3)/(1+B2)+B4+B5+B6*(B1-B2)
Step 1, the carry. The class sells dollars forward and buys euros. Covered interest parity prices the forward at a discount equal to the rate differential: (1.0225 / 1.0425) − 1 = −1.92 per cent a year. That is the largest item, and it is not a fee: it is the euro investor earning euro rates on the currency exposure instead of dollar rates. If euro rates were higher than dollar rates, the same line would be a gain.
Step 2, dealing and administration. 0.05 per cent for the forward spread and 0.03 per cent for the hedging agent: 0.08 per cent. Small, and charged to the hedged class only.
Step 3, the buffer. The class keeps 3 per cent of its NAV in cash so it can pay a losing forward without selling assets. That cash sits in the fund's dollars and earns 4.25 per cent instead of the fund's 9.0, a drag of 3% × 4.75 points = 0.14 per cent. Do not measure it against the euro rate: the cash is hedged with the rest of the NAV, so its conversion to euro rates is already in the carry line, and counting it twice overstates the cost.
Total: 1.92 + 0.08 + 0.14 = 2.14 per cent a year. The class returns 6.86 per cent. On a 1,000,000 subscription that is 21,410 a year, and after five years the euro client holds 1,393,337 against the 1,538,624 that 9.0 per cent would have compounded to, a difference of 145,287.
A forward that loses money settles in cash at the roll date. If the dollar rises 8 per cent against the euro over a quarter, the class's dollar assets are worth 8 per cent more in euros, but those assets are private loans or equity and cannot be sold. The forwards, however, have lost 16.0 million on a 200 million notional, and that is payable now.
| Adverse dollar move | Settlement | Buffer after the move | Shortfall | Share of the fund's 50 sleeve |
|---|---|---|---|---|
| 4% | 8.0 | 6.24 | 1.76 | 3.5% |
| 8% | 16.0 | 6.48 | 9.52 | 19.0% |
| 12% | 24.0 | 6.72 | 17.28 | 34.6% |
The class is 40 per cent of the fund, yet after its 6.0 buffer, itself worth more in euros once the dollar has risen, an 8 per cent move takes nearly a fifth of the whole fund's liquidity sleeve, and a 12 per cent move more than a third. Those draws compete with redemptions for the same cash, often in the same quarter, because a sharp currency move is also when wealth clients redeem. See how big an evergreen liquidity sleeve should be for sizing the sleeve against redemptions alone.
| Dollar rate minus euro rate | Carry | Total cost | Hedged class return |
|---|---|---|---|
| 0 points | 0.00% | 0.22% | 8.78% |
| 1 point | 0.96% | 1.18% | 7.82% |
| 2 points | 1.92% | 2.14% | 6.86% |
| 3 points | 2.88% | 3.10% | 5.90% |
The class's cost is almost entirely a function of central bank policy, which the manager does not control and cannot promise. A hedged class launched when rates were level will look 2 points worse two years later without anything changing in the portfolio.
Presenting the hedged class's underperformance as a fee, or worse, not presenting it at all. The advisor compares the euro class with the dollar class on the factsheet, sees 2.14 points of difference and concludes the euro class is expensive. Show the carry as a separate line in the fee stack, with the rate assumption next to it, and explain that it is the price of removing the currency, not of the manager. The fee stack itself is worked in how much of a semi-liquid fund's return the fees take.
The second mistake is operational: agreeing a hedged class without a settlement plan. Decide in the documents whether settlements come from a class buffer, a fund credit facility or the sleeve, and test the plan at a 12 per cent move.
The book treats the vehicle's liquidity terms and the fee stack as part of the product, not the paperwork; the free workbook and working documents for the book include the total-cost sheet and the new-class test.
Mainly because of the interest rate differential priced into the forwards. With dollar rates at 4.25 per cent and euro rates at 2.25, a euro class hedging dollar assets gives up 1.92 per cent a year, plus 0.08 of dealing and 0.14 of buffer drag. It is not a manager fee and reverses if euro rates exceed dollar rates.
Only the hedged class: forward costs, gains and losses and the agent fee are allocated to it, not to the base class. Its liquidity effect is shared, though. Settlements on a 200 million class after an 8 per cent move need 16.0 million, and the 9.52 million not covered by the class buffer can draw on the whole fund's sleeve.
Yes. If the dollar rises 8 per cent, the dollar assets are worth more in euros but cannot be sold, while the forwards lose 8.0 per cent of the class NAV in cash at the roll. A 12 per cent move needs 24.0 million on a 200 million class, 34.6 per cent of a 50 million sleeve after the buffer.
This article is one calculation from The Private Wealth Fundraiser. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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