You will be able to decide whether to use a currency-hedged class for a given holding.
On Farhan's broker, his global government bond fund comes in two versions. One is plain. The other has "USD Hedged" at the end of its name and a slightly higher TER. After lesson 5.2, What currency moves do to your returns in SGD, he knows currency can wipe out a year of bond returns. He wants to know whether the hedged version fixes that, and what it costs.
Hedging can help, and it is easy to misread what it does. This lesson covers how it works, where it earns its place, and the trap that catches Singapore investors in particular.
A hedged share class holds the same investments as the plain one, and adds a layer of currency contracts on top. These contracts, usually rolled over every month, lock in an exchange rate for an amount roughly equal to the fund's foreign holdings. When a foreign currency falls, the contracts gain, and when it rises they lose, so most of the currency effect cancels out. What is left is close to the return of the investments in their own currency.
The hedge is never perfect. The contracts are reset periodically, so if the fund's value moves a lot between resets, part of the currency effect slips through. The fund's documents describe the method and how closely it aims to hedge.
There is also a cost, and it comes in two parts. One is the running cost of the contracts and the trading, which is often reflected in a slightly higher TER or a wider tracking difference. The other is larger and less obvious, and it depends on interest rates.
The price of locking in a future exchange rate depends on the gap between short-term interest rates in the two currencies. If the currency you hedge into has lower short-term rates than the currency you hedge out of, the hedge costs you roughly that gap each year. If it has higher rates, the hedge adds roughly the gap.
Made-up example: if short-term rates in the currency the fund's bonds are in are 2 points higher than in the currency you hedge into, the hedge takes about 2% a year off your return. For a bond fund returning a few percent, that can be most of the return. In another period, with the gap reversed, the same hedge adds return.
Interest rate gaps change with each country's monetary policy, so this cost is not fixed. Check the fund's disclosed costs and its recent performance against the unhedged class, and check again at your yearly review.
Hedging is more common for bonds than for shares, and lesson 5.2 explains why. For high-quality bonds, the aim is stability. A currency swing that can be larger than the bond's whole return defeats that aim, so removing it brings the bond part of your portfolio back to doing its job: falling little when shares fall hard.
For shares, the case is weaker. Share prices already swing far more than currencies, so hedging removes a smaller part of the total movement, and over long periods currency effects partly even out. Some investors hedge part of their shares for a smoother ride. Many leave shares unhedged and keep the hedging cost.
Here is where Singapore investors need to read carefully. A hedged class removes currency risk only between the fund's holdings and the currency it hedges to. That currency is named in the share class, and SGD-hedged classes are rare. Most hedged classes available on the main exchanges hedge to US dollars, British pounds or euros.
Take Farhan's two options. His plain global government bond fund holds bonds in US dollars, euros, yen and other currencies, and he measures his results in Singapore dollars, so every one of those currencies affects him. The USD-hedged class removes the euros, yen and the rest, and leaves him holding something that behaves like a US dollar bond fund. He has swapped a basket of currency risks for a single one, the US dollar against the Singapore dollar. That may be an improvement, since one exposure is easier to understand, but it is not the same as having no currency risk at all.
There is a third route worth putting next to the two. A bond fund that holds Singapore dollar bonds, such as one tracking a Singapore government bond index, has no currency layer for a Singapore investor at all. The trade-off is concentration: its bonds come from one government or one market, where the global fund spreads across many. Whether that trade-off is acceptable depends on the home bias limit you set after lesson 5.1, Home bias: holding too much of what you know.
So for any hedged class, ask three questions. Which currency does it hedge to? What does the hedge cost now, given the rate gap? And what currency risk is left for you, measured in Singapore dollars?
Farhan writes all three answers for his two bond classes, then adds a third line for a Singapore government bond fund. His decision waits for lesson 5.4, Set your home and currency limits. Yours can start the same way, with your own bond holding and those three questions.
For your bond holding, compare a hedged and unhedged class on cost and on the currency they hedge to, and pick one.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).