Chinext Investment Radar: Should You Choose 'Hedged Share Classes' for Overseas Funds? 3 Key Points and Hidden Costs You Must Understand Before Investing

Have you ever wondered: "I invested in a high-yield bond fund denominated in South African rand with a 10% dividend yield, and the underlying assets performed well, yet when I converted back to New Taiwan dollars after a year, my account showed a loss?" Or perhaps you've experienced this: "I picked a U.S. stock fund, gained 20% from stock appreciation, but due to the U.S. dollar's sharp decline against the New Taiwan dollar, most of my profits were wiped out..."

Many new investors in overseas funds focus solely on the performance of the underlying assets, often overlooking the double-edged sword of 'exchange rates.' Even if the stocks or bonds the fund invests in rise in value, if the fund's denomination currency depreciates significantly against the New Taiwan dollar, your final return when converting back can still shrink. This is where 'hedged share classes' come in, designed specifically to mitigate such currency volatility.

1. What is a Hedged Share Class?

Hedged Share Class vs. Hedge Fund

Before understanding hedged share classes, a common misconception must be clarified: a hedged share class (Hedged Class) is entirely different from a hedge fund (Hedge Fund).

Hedged Share Class: This hedges against 'currency risk' and is simply a different 'currency version' of the same fund.

Hedge Fund: This hedges against 'market downturn risk.' It is a specific investment strategy and fund type that uses short selling, leverage, and arbitrage with derivatives to achieve returns that outperform the broader market.

Simply put, a hedged share class is like different colored wrapping paper on the same apple—the contents (the assets the fund invests in) are identical. A hedge fund, on the other hand, is a completely different fruit.

Definition and Operation of Hedged Share Classes

In simple terms, a hedged share class aims to 'shield investors from currency fluctuation risk.' For example, consider a New Taiwan dollar investor buying a 'U.S. dollar-denominated, investing in Japanese stocks' U.S. dollar hedged share class fund (assuming a 4% yield on U.S. short-term government bonds and a 1% yield on Japanese short-term government bonds):

Subscription: Investor deposits New Taiwan dollars → converted to U.S. dollars → the fund buys U.S. short-term bonds and simultaneously borrows Japanese yen → the fund uses the borrowed yen to purchase Japanese stocks.

Redemption and Hedging Termination: The fund sells Japanese stocks → repays the Japanese loan (paying 1% interest cost), sells U.S. bonds (earning 4% interest income) → converts U.S. dollars back to New Taiwan dollars.

Hedged share class funds primarily use 'foreign exchange forward contracts' to lock in future exchange rates, thereby eliminating the exchange rate risk between 'USD/JPY' and 'JPY to USD' that would exist in an unhedged scenario. The core of this operation is: buying U.S. short-term government bonds to earn interest while borrowing Japanese yen to invest in stocks. The 3% interest rate differential (4% - 1%) becomes additional income from the hedging operation. As long as U.S. interest rates are higher than Japanese rates, the fund can achieve a 'positive USD/JPY interest rate differential,' achieving the goal of 'reducing the impact of yen exchange rates while earning the interest rate spread.'

It is crucial to note that the hedged share class locks in the exchange rate between the 'fund's denomination currency' and the 'asset's currency' (i.e., USD/JPY), but it does not mean the risk of 'New Taiwan dollar against U.S. dollar' is also hedged. If the New Taiwan dollar appreciates significantly against the U.S. dollar, the fund may still face exchange rate losses when converting U.S. dollars back to New Taiwan dollars—a risk many investors easily overlook!

Source: Compiled by 'Chinext Buy Funds'.

2. What are the Advantages, Disadvantages, and Hidden Costs of Hedged Share Class Funds?

Hedged share class funds can reduce the uncertainty of exchange rates, allowing investors to focus solely on assessing the performance of the underlying assets. They are also suitable for investors who prefer high-yield currencies but do not want to bear the risk of currency depreciation. When the fund's denomination currency has a higher interest rate than the asset's currency, the hedging operation itself can even generate additional positive returns. However, it is not without cost: the interest rate differential between the two countries can reverse and become a hedging cost that erodes returns. If the asset's currency appreciates, the hedged share class cannot participate in that exchange rate gain. Additionally, because hedging operations use derivatives for dynamic adjustments, tracking errors may still occur during periods of market volatility, making it impossible to achieve 100% perfect hedging.

3. Performance Comparison of Different Share Classes in the Same Fund

Whether or not a fund is hedged can lead to significant differences in actual returns. In recent years, due to the U.S. dollar's substantial appreciation against the Japanese yen (yen depreciation), unhedged 'U.S. dollar' and 'yen' share classes have suffered exchange rate losses, with a cumulative three-year return of approximately 75%. In contrast, the hedging mechanism not only avoided this layer of exchange rate risk but also generated excess interest rate spread returns in an environment where the interest rate gap between Japan and the U.S., South Africa, and Australia was large, driving the cumulative three-year returns of the three hedged share classes above 100%. Notably, the South African rand hedged share class, due to the extremely large interest rate differential between South Africa and Japan, achieved a cumulative three-year return as high as 172.4%. It is important to note that this interest rate advantage shows a smaller gap in the short term (1-3 months), but over longer periods of 2-3 years, the compounding effect of time significantly widens the gap. This is the tangible return brought about by the long-term accumulation of 'interest rate differentials' between two countries.

Investors must pay special attention: The choice of share class should be based on 'the currency you actually hold and will use in the future,' not simply on comparing the historical return rates. If an investor holds New Taiwan dollars but subscribes to a share class denominated in a non-held currency like Australian or South African rand (regardless of hedging), they will still bear the exchange rate risk of 'New Taiwan dollar against that class's currency' when converting back. This risk is outside the fund company's hedging scope and will not be reflected in the return figures published by the fund company, making it easy for investors to overlook. In other words, the first principle of choosing a share class is to first confirm 'whether the denomination currency of this class is the currency you actually hold or need,' and then further consider whether to hedge.

4. Practical Guide — Should You Choose a Hedged Share Class?

After reviewing the pros and cons, let's return to the most practical question: which one should you choose? There is actually no standard answer; the key lies in your capital's nature and investment goals. (To learn how to identify and select suitable hedged share class funds, please refer to: Invest in foreign currency funds without fear: How to choose to avoid exchange losses!)

People who may consider choosing a 'hedged share class':

Income-focused / Retirees: Those seeking stable monthly cash flow who cannot tolerate exchange rate fluctuations affecting their principal and dividend amounts. A hedged share class can make dividends more closely reflect the underlying asset's performance, resulting in lower volatility.

Those sensitive to exchange rates and who do not want to speculate on exchange rate movements: If you want to focus your energy on judging market trends (e.g., whether Japanese stocks will rise) and do not want to 'earn on stock prices but lose on exchange rates,' choosing a hedged share class may help reduce some of the interference caused by exchange rate fluctuations.

People who may consider choosing a 'general/unhedged share class':

Long-term investors / Capital gains-focused investors: In the long term, exchange rates often exhibit mean reversion (or exchange rate fluctuations are considered part of asset allocation). Choosing an unhedged share class can save on the hedging costs of derivatives and tracking errors, allowing full participation in the market's long-term growth.

Those who anticipate the asset's currency will rise in the future: If you predict the asset's currency will significantly appreciate in the future (e.g., investing in Japanese stocks and expecting the yen to strengthen), choosing an unhedged share class (such as directly buying a yen-denominated class or an unhedged U.S. dollar class) offers the opportunity to benefit from gains in both the asset and the exchange rate. (For more on selecting assets under different Japanese economic scenarios, please refer to: Japan's interest rate hike cycle begins, where are the investment opportunities?)

Chinext Investment Strategy

Hedged share classes are not a guaranteed win! Investors should choose the appropriate fund share class based on their own needs.

A hedged share class is not a tool to increase returns but a tool to manage currency risk. Whether you should choose it depends on whether you want to bear the risk of exchange rate fluctuations or the interest rate differential between two countries. It does not completely free investors from currency risk (especially when the investor's held currency is not the fund's denomination currency or hedging currency), nor does it guarantee long-term performance will always outperform the original currency class. Before placing an order, investors should choose the most suitable fund share class based on their own risk tolerance, the future use of their funds, and the currency they actually hold, rather than being influenced solely by the superficial sense of security from the word 'hedged.'

Chinext Selected Funds

B23573 Schroder Global - Global Income Growth Fund Subscribe

B05044 Allianz Japan Equity Fund (USD Hedged) Subscribe

B25186 Mairs & Partners U.S. Small Company Opportunities (AUD Hedged) Subscribe

'Chinext Buy Funds' is independently managed and operated.

This information is for reference only. 'Chinext Buy Funds' has made every effort to provide accurate opinions and information from reliable sources but cannot guarantee the completeness of such data. In accordance with the latest relevant regulations of the Financial Consumer Protection Act, to provide better investment services to investors, our company implements an 'Investment Attribute Assessment' procedure. By completing the 'Investment Risk Suitability' assessment on the Chinext Buy Funds website, our company will regulate product suitability based on customer attributes and request you to update it at least once a year. Failure to complete the attribute assessment may affect your transactions.

Fund transactions are intended for long-term investment and should not expect to achieve high returns in the short term. The price of any fund units and their income may fluctuate, and past performance is not indicative of future results.