For alternative asset managers and global funds, fluctuations in foreign exchange rates may erode performance, even if the underlying investments deliver positive returns.
To protect non-base currency gains, many fund managers employ hedging strategies to protect net asset values (NAV), thereby locking in returns in the investor’s currency and reducing the possibility of a drag from foreign exchange (FX) exposure.
What is NAV hedging?
NAV hedging can be an effective strategy for funds that hold investments in different currencies.
Calculated as the total value of a fund’s assets minus its liabilities, the NAV provides the basis for valuation and performance of the underlying fund.
NAV hedging is a currency risk management strategy where a fund hedges assets or liabilities that are in different currencies to the fund’s base currency, to neutralize the impact of FX volatility on the fund’s performance.
What is share class hedging, and what is its relation to NAV hedging?
Share class hedging is a currency risk management strategy where an investment fund hedges the foreign exchange exposure for a specific share class, rather than for the entire fund. This ensures that investors in that share class experience returns in their chosen currency without being affected by currency fluctuations.
Key difference from NAV hedging:
- NAV hedging protects the whole fund’s value in its base currency.
- Share-class hedging protects individual investor classes in their preferred currency.
More generally, share class hedging aims to reduce the impact of exchange rate movements between an investor’s currency and a fund’s base currency.
When an investment fund holds overseas assets or raises capital in one currency and invests in another, it exposes investors to currency risk. This, in turn, may hurt overall performance if exchange rates move unfavorably between the time of investment, valuation, and settlement.
NAV hedging strategies aim to manage or eliminate the impact of currency fluctuations on the fund’s reported NAV from the fund’s base currency. In effect, this seeks to preserve the value of the investment in the fund’s base currency, irrespective of underlying FX swings.
By hedging the NAV, a fund manager can mitigate volatility arising solely from FX risk, such as when a local currency loses its value relative to the investor’s currency.
Where NAV hedging overlaps share class hedging
NAV hedging and share-class hedging can overlap when a fund applies both strategies simultaneously. NAV hedging is used to protect the entire fund’s value in its base currency, reducing the impact of foreign exchange movements on the overall portfolio. Share-class hedging, on the other hand, is designed to shield individual investor classes from currency fluctuations by hedging their specific currency exposure.
When both are implemented, some currency risks are managed twice: first at the fund level through NAV hedging, and then at the share-class level to ensure investors receive returns in their chosen currency without being affected by the NAV hedge. This layered approach provides stability for the fund as a whole and for each investor class individually.
When to use the NAV hedging strategy
In a globalized investment world, fund managers can’t afford to overlook FX risk simply because it’s beneath the surface of asset performance. NAV hedging offers a way to protect investor returns from the often-unseen drag of currency movements.
There are several compelling reasons why fund managers and investors favor NAV hedging:
- Stabilizing investor returns
A fund may perform well locally, but if the local currency weakens relative to the investor’s base currency, the return may be significantly impaired. For example, a USD denominated private equity fund with euro-denominated assets might forecast a 20% IRR, but if the EUR depreciates vs. the USD, the USD return falls should the fund manager leave that exposure unhedged. By hedging currency risk, the fund shields investors from currency-driven risks, keeping the focus on the primary investment. - Enhancing global competitiveness
In markets where capital is raised in USD or globally, the ability to offer “USD-result” clarity may be a differentiator. A fund that invests abroad but provides hedged USD returns may be more appealing to US-based or dollar-based limited partners. - Improving investor confidence and fundraising
Investors increasingly expect clarity around FX exposure. Using NAV hedging signals to capital allocators that the manager has considered all elements of return risk, not just asset selection.
Considerations for choosing a hedging approach
Convera offers a variety of FX hedging strategies* that may be a good fit for your international fund. However, before diving into a particular vehicle to protect your assets, it’s important to do your due diligence and make sure NAV hedging is an appropriate value-add for your investors.
In the case of Prisma Capital, Convera helped the Brazilian asset manager facilitate NAV-hedging strategies to manage FX risks and gave offshore investors greater confidence in their USD returns, resulting in a successful capital raise.
The NAV hedge reduced the risk that local currency depreciation would wipe out otherwise positive performance. By managing FX risk actively rather than passively leaving it to investors, Prisma strengthened its global investment opportunities.
In addition to determining if a NAV hedge fits your fund’s model, it’s also important to conduct a thorough cost analysis to define your FX risk. Key steps to follow include:
- Identify the key currency-mismatch exposure
Whether the fund raises in USD but invests in a local currency such as yen, or investments are denominated in foreign currency relative to investors, the first step is to map the currency mismatch. - Select an appropriate hedging instrument and structure
For restricted currencies or emerging markets, non-deliverable forward (NDF) contracts are a useful tool for hedging on currency movements when one of the currencies can’t be freely traded or converted — typically due to capital controls or government restrictions. NDFs may be more practical than deliverable forwards, so it’s important to assess instrument cost, liquidity, tenor flexibility, and settlement mechanics. - Align hedges to NAV updates and the investment cycle
The hedge needs to track NAV (or investor currency exposure) — not just static assets. In Prisma’s case, the monthly hedge adjustment aligned with updated NAV figures. Failure to update hedges can create mismatches and residual exposures. - Manage the collateral/credit cost of hedging
NAV hedging often requires posting collateral or margin. Selecting a partner who understands the fund’s needs and can offer efficient credit terms is critical. - Communicate clearly to investors
Investor confidence can be enhanced when they understand that FX exposure is actively managed. Clear disclosure of hedge policy, hedge ratio, costs, and reporting transparency are all important. - Acknowledge hedging cost and trade-offs
While hedging reduces downside from adverse FX moves, it also reduces upside if currency moves favorably. The fund must weigh the cost and decide on a hedge ratio accordingly.
Building a stable global strategy
When setting up financial controls and risk management strategies for an international fund, managers should keep in mind that NAV hedges may not be effective for every type or investor base, including those looking to benefit from currency appreciation or FX volatility.
When currency exposure is small compared to overall returns, the cost of hedging may outweigh its benefits. Or, if liquidity and collateral constraints make hedging onerous, it might make more sense to avoid these tactics. Additionally, some investment funds’ risk/return profiles already accommodate FX volatility as part of their investment thesis, making an additional layer of complexity somewhat redundant.
To ensure these strategies make sound financial sense, consult with an experienced FX and cross-border payments partner. Offering access to over 140 currencies across more than 200 countries and territories, Convera can make the task of FX risk management much smoother for international fund managers and safer for their investors.
*Convera’s hedging products are derivative financial instruments which may expose you to risk should the underlying exposure you are hedging cease to exist. They may be suitable if you have a high level of understanding and accept the risks associated with derivative financial instruments that involve foreign exchange and related markets. If you are not confident about your understanding of derivative financial instruments, or foreign exchange and related markets, we strongly suggest you seek independent advice before making the decision to use these instruments.
