Mutual funds: To hedge or not to hedge

Expect increased currency volatility in 2025 due to divergent global monetary policies
Hedged/unhedged choice depends on risk tolerance and expected currency movement
The Hedged/unhedged choice directly impacts investment total returns

When scouring for a mutual fund, there may come a time when one comes across the options of 'hedged' and 'unhedged' classes. What sets them apart? And how should investors choose between them?

Simply put, a hedged class employs financial tools to mitigate the impact of currency volatility on total returns. As for an unhedged class, its returns can be affected by currency fluctuations. There is no definitive answer as to which one is better. The choice boils down to one's tolerance for currency risk, and projection of the currency outlook. Broadly speaking, if an investor does not have the appetite for currency risk, has limited visibility on currency movements, or expects the currency trajectory to negatively impact returns, a hedged class may be preferred. On the other hand, If one believes the currency outlook will enhance returns, or is relatively comfortable taking short-term currency risk, an unhedged class may be considered.

Let's explain further with the example below.

How currency hedging – or not – impacts returns

Each fund only has one base currency, but may offer classes denominated in different currencies, such as USD, RMB, HKD or AUD, to accommodate investors holding various currencies. In the following hypothetical example, an investor invests in the RMB unhedged class of a global equities fund with USD as the base currency. During the investment period, the USD-denominated assets delivered a 10% return, while the USD appreciated by 5% against the RMB. This brings total returns to 15%.

If the investor had chosen the RMB hedged class, the fund would lock in the exchange rate in advance using financial instruments, such as foreign exchange forward contracts, to reduce the impact of USD/CNY volatility on returns. If the USD appreciates against the RMB, hedging would partially offset the foreign exchange impact. Hence, the investor may only capture capital gain of approximately 10%, missing out on extra returns from the USD appreciation. However, it's worth bearing in mind that currency hedging comes with additional costs, and while it can help align returns closer with the base currency, it may not fully offset currency risk.

Now, let's assume the dollar reverses its strength. The fund's assets posted a 10% gain, but the USD depreciated by 5% against the RMB. Without currency hedging, the return is reduced to about 5%, weighed down by USD weakness. However, if the currency is hedged to offset FX volatility, the return would remain around 10%.

(The above data is for illustrative purposes only and does not represent actual investment returns and performance)

Global monetary policy divergence to drive currency volatility

Persistent divergence in global central bank policies will shape currency trends. US economic resilience is expected to continue driving global capital markets. After delivering three rate cuts last year, the Fed indicated that interest rates will remain elevated for the foreseeable future by keeping policy restrictive. Meanwhile, the European central bank has repeatedly lowered rates to bolster growth, while China has indicated its intention to adopt a moderately loose monetary policy to stimulate its economy. Although Japan raised rates again in January, the policy gap between the US and Japan remains significant. While the USD is holding up well against currencies such as the EUR, GBP, RMB, and JPY, this trend may not necessarily persist. Should US President Donald Trump's policies rekindle inflation or dampen US growth, it may disrupt the monetary policy path and lead to increased currency volatility.

We believe that risk management would be a key investment focus in 2025, with currency volatility being one of the many risks. The choice between a 'hedged' or 'unhedged' class may impact returns. Therefore, currency risk should be considered when making investment decisions, or one can seek guidance from investment professionals.