International FoF Mutual Funds — Currency Risk & Hedging Basics

What is an International Fund-of-Funds (FoF)?

An International FoF is a mutual fund that invests primarily in overseas funds (ETFs or mutual funds) rather than directly in foreign stocks or bonds. The underlying funds hold assets denominated in foreign currencies (USD, EUR, JPY, etc.), so the FoF’s returns for an INR investor combine (a) the performance of the foreign assets and (b) the change in exchange rates between INR and the foreign currency.

The three types of currency risk investors face

1. Transaction risk — The gain or loss when converting investment proceeds between INR and the foreign currency (e.g., buying US equities in USD then converting gains back to INR).

2. Translation risk — Accounting effects when a fund’s foreign-currency NAV is reported in INR; swings can distort short-term returns.

3. Economic risk — Persistent currency moves that change the real value of future earnings and dividends from foreign assets.

All three affect FoF returns; translation and transaction risk are the most visible to retail investors. Historical episodes show currency moves can be as large as or larger than asset returns — so currency is not a trivial factor.

How do fund managers hedge currency risk?

• Currency forwards: Over-the-counter contracts that lock a future exchange rate for a specified notional and date. These are widely used by funds for cost-efficient hedging.

• Currency futures: Exchange-traded contracts that provide standardised hedging and margining.

• Currency swaps: Exchange of cash flows in two currencies; used for longer dated hedges or to synthetically alter foreign currency exposure.

• Currency options: Provide the right (not obligation) to exchange at a strike — useful for asymmetric hedges but costlier.

For most International FoFs, short-dated forward contracts are the practical choice because they are liquid and match the fund’s rolling exposure; managers typically roll these hedges periodically (monthly or quarterly). Hedging can reduce return volatility but also introduces costs that can reduce long-term returns.

Hedged vs Unhedged Funds — the trade-offs

Hedged funds (currency-protected)

Pros

• Reduce return volatility caused by currency swings; the fund’s INR returns more closely track the foreign asset performance.
• Useful when the domestic currency (INR) is volatile or if the investor’s liabilities are in INR.

Cons

• Hedging costs (bid-ask, forward points, swap spreads) eat into returns. When the foreign currency appreciates vs INR, a hedged fund may underperform an unhedged one.
• Hedging can trigger taxable events or additional accounting complexity in some jurisdictions.

Unhedged funds (currency-exposed)

Pros

• Potential upside if the foreign currency strengthens against INR; no hedging cost drag.
• Simpler structure and sometimes lower ongoing costs (no rolling forward costs).

Cons

• Greater volatility — currency moves can amplify or offset the underlying asset returns unpredictably.
• For investors needing rupee-stability for near-term goals, unhedged exposure can be risky.

A practical middle ground used by some managers is partial hedging (hedge 50–75% of currency exposure) or dynamic hedging (adjust hedge ratio based on market conditions). Empirical studies show that the best choice depends on the investor’s horizon, domestic currency outlook, and tolerance for volatility.

Cost of hedging — what eats your returns

Hedging is not free. Costs include:

• Forward points / swap cost: Reflect interest rate differentials between currencies (covered interest parity). When the foreign currency has a higher interest rate, hedging it back to INR costs money.
• Transaction & roll costs: Funds roll short-dated hedges regularly; each roll incurs bid/ask and brokerage costs.
• Operational / counterparty costs: OTC hedges need reliable counterparties and back-office capability.

These costs can be material over time — studies and industry surveys show hedging can reduce volatility by 10–15% but may also shave basis points off long-term returns depending on the interest rate environment and hedging efficiency.

When does hedging make sense for an Indian investor?

• Short to medium horizon goals (≤5 years): Hedging is generally preferable because currency volatility can swamp asset returns over short periods.
• Liability matching in INR: If you need rupee cashflows (education, EMI, planned purchases), hedged funds protect purchasing power.
• Low risk tolerance: Hedged funds lower portfolio volatility, which many conservative investors prefer.

When to avoid hedging: Long-term investors seeking maximum diversification may accept currency exposure since currency effects can even out over decades and add diversification benefits to the portfolio. Historical research suggests currency effects often “wash out” over very long horizons.

Regulatory & operational notes for India

Indian funds must follow RBI/SEBI rules for foreign investments and derivative usage. Hedging operations involve OTC forwards and swaps that require careful counterparty selection and operational controls. Retail investors should check fund documents (SID/KIM) for hedging policy, hedge ratio, and historical hedging cost/efficacy. RBI guidance on hedging and derivative use provides the regulatory backdrop for how funds implement currency risk management.

Practical checklist for investors

1. Check fund’s hedging stance — fully hedged, unhedged, partial or dynamic.<br>
2. Compare hedging costs — look for historical expense disclosure and roll costs.<br>
3. Look at volatility & returns net of hedging — compare hedged vs unhedged variants of the same strategy.<br>
4. Match to your horizon & goal currency — hedge for INR liabilities; consider unhedged for very long horizons.<br>
5. Monitor tax and distribution rules — hedging can affect realized gains and reporting.<br>
6. Diversify across currencies — if possible, avoid sole exposure to one foreign currency (e.g., USD) unless intentional.
 

Conclusion

Currency risk is a real and sometimes dominant factor in returns from International FoFs. Hedging reduces rupee-return volatility and protects short-term goals, but it comes with explicit costs and occasional underperformance when the foreign currency strengthens. There is no one-size-fits-all answer: choose hedged funds for near-term rupee needs and lower volatility, and unhedged funds if you are a long-term investor willing to accept currency swings for potential diversification gains. Always read the fund’s hedging policy, compare hedged vs unhedged variants, and align the choice with your investment horizon and liability currency.