A new look at hedged share classes

Introduction

In 2019, we published a research article examining the FX hedging performance of investment funds sold to institutional investors in Switzerland when compared to an independent and specialized currency risk manager. The results showed an average yearly under-performance of the funds’ FX hedging of 15 basis points between 2013 and 2018.

Over the years since, clients and Swiss investors in general have repeatedly asked us for additional insights into these numbers as well as dedicated analyses of particular funds in their portfolio. This continued interest in the topic has led us to revisit our original research, five years after its publication.

Since 2019, funds’ FX hedging performance has degraded to -20 basis points per year on average. This article details how this underperformance varies across funds’ characteristics and offers an explanation as to why it should be expected to persist over time.

Methodology
Once again, our focus centers on funds invested in USD-denominated assets. The reason for this choice is twofold. First, US assets dominate the foreign exposures of Swiss investors. Second, having a single currency exposure greatly enhances the precision of the analysis as we do not have to estimate time-varying weights across several regions and their respective currencies.

Our sample totals 116 funds (232 share classes; one hedged and one unhedged), compared to 66 in our prior analysis, and covers the years 2019 to 2023. Putting implicit costs aside for now, a natural starting point is to examine explicit FX hedging costs, meaning as they are reported by fund issuers.

How much do funds charge for FX hedging?

	2024	2019
Number of funds	116	66
Share of funds charging FX hedging fees	41%	33%
Average hedging fee	0.04%	0.05%
Median hedging fee	0.05%	0.04%
Lowest hedging fee	0.01%	0.01%
Highest hedging fee	0.14%	0.12%

Comparing the Total Expense Ratio (TER) of the hedged and unhedged share class reveals whether the fund charges additional fees for the FX hedging and, if yes, how much. The resulting statistics are presented in the table above, along with our 2019 findings for comparison.

Although the average, median and lowest FX hedging fees stayed stable over the past five years, the percentage of funds charging higher fees for their hedged share class increased from 33% to 41%. This is quite surprising given the prevailing trend in the investment industry for ever lower management fees. An event that could be the cause of this discrepancy is the implementation of the European MiFID II regulation in 2018 which, among other things, requires funds to publish a broader set of total costs borne by investors. Nevertheless, the highest hedging fee at 14 basis points (up from 12 in 2019) remains astonishing.

But even the average hedging fee, at 4 basis points, is inexplicably high given that a specialized currency overlay manager would typically charge around 1 basis point to implement this type of (passive) currency hedging.

Now, how much does it really cost?

Investors now recognize that explicit fees are only one aspect of the total costs dragging on their returns. In our context, the implementation of the hedges, from process to transaction execution quality, incurs costs that can only be unveiled by comparing bottom line performances, which is what we turn to now.

For each fund and year, we subtract the performance of the hedged share class from that of the unhedged one. This allows us to isolate the (total) FX hedging component given that both share classes are identical in their investments except for the FX hedge. The FX hedging component is then compared to the one implemented by a specialized currency overlay manager. We present our results in the histogram below, where each observation is the FX hedging under- or over-performance of a fund over the specialized manager for a given year.

The distribution, as represented by the grey rectangles, shows a negative skew, meaning that it is rather concentrated to the left of the red line delimiting negative and positive values. This implies that funds tended to under-perform the specialized FX overlay manager in terms of currency hedging. More precisely, this occurred 72% of the time and resulted in an average yearly under-performance of -0.20%.

Recall our discussion of explicit hedging costs where a minority of funds (41%) charged additional fees for the FX hedging service with an average of 0.04% per year. Our analysis of total costs (i.e. both explicit and implicit) shows that funds underperform a specialized currency risk manager most of the time (72%) and that the average cost is five times worse (-0.20%) as what could be inferred from the funds’ documents. Importantly, these total costs can only be exposed by having access to an appropriate benchmark, in this case the performance of the specialized currency manager. The numbers align broadly with our 2019 results (79% and -0.15%, respectively). If anything, funds reduced their probability of underperforming slightly, but when they did, their underperformance was worse.

All funds are not created equal

We now turn our attention to fund characteristics to investigate whether they have an effect on FX hedging underperformance.

In addition to the Total Expense Ratio (TER), we focus on fund size (in terms of assets under management – split evenly between large and small) and management style (active – where the goal is to beat a reference index – or passive – where the goal is to replicate a reference index). For each group, we measure how the average annual FX hedging performance compares with that of the specialized manager. The results can be found in the table below.

In summary, and other things being equal, funds that do not charge FX hedging fees, are small and have a passive management style have worst total FX hedging costs than those who do charge FX hedging fees, are large and have an active management style. Strikingly, funds not charging (explicit) FX hedging fees incur total costs that are almost three times larger than funds that do, underlining the importance of looking beyond cost figures as they are reported by fund issuers.

Funds' (total) FX hedging costs as a function of their characteristics

	Average yearly total FX hedging cost
Funds charging FX hedging fees	-0.10%
Funds not charging FX hedging fees	-0.27%
Large funds	-0.10%
Small funds	-0.31%
Active funds	-0.12%
Passive funds	-0.35%

Putting it all together

How can these various effects be explained? In this section, we offer an explanation based on the mechanics of funds’ FX hedging.

To start off, consider a fund’s hedged-share class as an independent portfolio made of:

some underlying investments (e.g. US stocks or bonds), and
a FX hedge in the form of forward contracts in the corresponding currency pair (i.e. USDCHF).

Now consider the following two scenarios, depending on the movement in US interest rates:

Too many transactions The first thing to note is that, since the share class operates as an isolated compartment, any (realized) gain or loss on the FX hedge requires a buying or selling transaction in the underlying investments to either reinvest the gain or cover the loss. While the fund's management theoretically has discretion over the frequency of these transactions, in practice, they are strongly influenced, sometimes even bound, by the methodology of their reference index.

This methodology is surprisingly similar across the whole range of index providers: at the start of each month, the whole of the FX exposure is hedged using forward contracts with a 1-month maturity. This strategy, while clear and easily reproductible, has several major downsides:

It leads to a large FX hedge turnover, equivalent to 12 times the value of the portfolio per year, resulting in
significant transaction costs, and
higher hedging costs due to the negative effects that typically affect 1-month forward at the turn of the year and quarter (“cross-currency basis”).

Now, let's reconsider our previous findings in light of this hedging methodology.

Volatility

Recall that funds’ FX hedging performance worsened further in our most recent sample.

A few computations show that the yearly volatility of US stock and bond returns in our original sample (2013-2018) was 11.11% and 2.88% respectively, with 7.81% for the USDCHF pair. In our later sample (2019-2023), these numbers changed to 18.81%, 5.58% and 7.17%.

The highlighted hedging methodology implies that the large increase in assets’ volatility (+70% for stocks and +90% for bonds) should have led to larger FX hedge adjustments and thus higher transaction costs in our second sample. This aligns with the worsening of the funds’ FX hedging that we observed.

Funds’ characteristics

The inefficiencies presented above are known to many market participants and asset managers who can take advantage of them. This excludes passive funds however since their task is to replicate the benchmark index’s performance (and thus its FX hedging strategy). On the other hand, active funds can hope to boost performance by adapting their hedging process to some degree and this is what we observed in our sample.

The same logic can apply to funds who charge a higher fee on their hedged share class: they are expected to provide a higher quality service in exchange for this added price compared to the simple replication of an inferior hedging strategy.

Finally, larger funds benefit from more significant resources and economies of scale, allowing them to reduce their transaction costs, resulting in better performance compared to their smaller counterparts.

Conclusion

FX-hedged investment funds are popular for their simplicity as they require no FX hedge management on the part of the investor. However, a close examination reveals that their inefficient FX hedging methodology and the associated transaction costs have led to continued and significant underperformance over the past decade.

The good news is that a similarly simple yet markedly better solution exists: delegating currency risk management to a specialized manager. This allows for the design of a sound, comprehensive, and efficient hedging program at a low and clear price. Only this level of transparency can demonstrate a complete alignment of interests with those of the investor.