Currency Management by International Fixed-Income Mutual Funds

Key Question Being Explored in This Insight:

How do U.S. international fixed-income funds manage currency risk, and what impact does hedging have on return variability and abnormal returns?

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Institution: National University of Singapore

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How do U.S. international fixed-income funds manage currency risk, and what impact does hedging have on return variability and abnormal returns?

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Always been interested in investment management,

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research in general, right?

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How portfolios are managed

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and, take into account the complexity of risks

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and returns in the real world.

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Um, and then what, really prompted this piece

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of research in particular is that in the last 10 years

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or so in the US market,

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and I guess in the European market as well,

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there has been a lot of growth in fixed income.

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Mutual fund used to be, when we talk about mutual funds,

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it's all about stocks.

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Now people invest in corporate bonds, sovereign bonds,

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through mutual fund structures.

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What is the key differences

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between managing a fixed income portfolio, relative

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to managing an equity portfolios?

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Right? Of course, the differences can be,

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in many dimensions, but I think one interesting aspect is

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that if you want to invest globally

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and you take currency risks, it actually is a bigger deal

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for fixed income mutual funds than for equity mutual funds.

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Why? Because, fixed income bonds themselves,

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their price would fluctuate,

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but not as much as equity, right?

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So I think if we talk to practitioners, the general idea is

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that if you manage a international fixed income portfolio,

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half the risk is coming from the bond itself,

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and half the risk is coming from currency fluctuation.

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And that's very different from,

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a international equity portfolio,

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where I think the generally, the census

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probably split is like 10% is currency

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and 90% is equity themselves.

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So you can sort of forget about currency

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for, for, from a larger part.

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So I thought that's an interesting starting point

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that separates out the difference of, what is,

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difficult for managing a inten international bond portfolio.

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Uh, so I went out seek out data on how much I can see

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what these guys are doing for,

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fixed income asset managers.

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Luckily the data is out there that tells us at least,

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at the quarterly frequency, what are they holding

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and how much additional curr derives they're using.

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And I can put two pieces together and, and,

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and kind of inform the question of

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what they're doing in their currency, risk management.

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That's a really interesting question

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because, bond market, if you're not too familiar

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with it, I think it's really interesting

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because you can have US issuers, companies

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and governments, obviously they issue US dollar

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denominated bonds, right?

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But if you go outside of us, take a European governments

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or corporate issuers,

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they may issue bonds in their home currency in Europe

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or in British funds, or they may choose to issue

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bonds denominated in US dollars

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because obviously US dollar is the international currency.

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A lot of financial market activity in USD.

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So if you are a US investor or a us fixed income

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before the manager and you want

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to manage the current exposure of a portfolio,

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one approach is to exclusively invest in global issuers,

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but only the US denominated bonds, right?

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That app that naturally cues off all the currency

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exposures from the get go.

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And I think in the data, there are some paper out there

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showing that there's indeed a currency home buyers

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that the investors tend to,

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just if US investors just tend to, hold,

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US dollar denominated bonds.

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But that approach is somewhat limiting

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because if you take a non-US issuer, let's say in Europe

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or in uk, if it's a big issuer, they tend

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to issue both in USD and in their home currency.

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But if it is a smaller company, then chances are

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that they only issue in their home currency, not not USD.

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So if you stick to the first approach

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of selecting only US dollar denominate bonds,

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you're limiting your invest investment universe, right?

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And naturally we have this, idea

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of the larger the universe you start

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with the better like diversification that you can achieve.

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So what can you do? You can actually not limit yourself

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to only US dollar denominated bonds.

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You go out, expose yourself

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to foreign currency denominated bonds, so you have a larger,

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wider set of issues you can choose from.

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But then, funds

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and portfolios can enter into ative contract

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to hopefully get rid of some if not all

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of their currency exposure.

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If you're a mutual fund manager, you enter into a contract

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with usually a large bank,

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and those contracts can either allow you

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to sell foreign currencies exchange to US dollars

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on our future date or vice versa, sell us dollar

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and buy for currency.

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So in the typical sense of hedging,

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if a US investor holds a foreign denominated assets like

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denominated in British bonds, what they can do is

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that they go to Barclays or they go to big bank

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and say, let's enter into a contract.

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We promise to deliver you x amount of British pounds,

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three months from now in exchange

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for y amount of US dollars.

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And that exchange rate basically is fixed at the time when

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they enter into the contract.

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So that that way this US investor don't have

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to worry too much about

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how much their British fund do assets,

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the valuation change relative to US dollars

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because at the end of day they get the,

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pre-agreed amount

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of US dollar from their counterparties, right?

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And this turns out to be the most, popular way

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for mutual funds in our sample to hedge their currency risk.

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And about 90% of them will have certain amount of,

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of foreign currency forwards, in their holdings.

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I'm gonna ask you what factors then influence the use

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of these forwards in international income funds?

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Yeah, so,

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the short answer is there are many factors, right?

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And let me unpack that a little bit.

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So about 10, 15% of our sample funds a minority of them,

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they actually have a very explicit mandate

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of fully hedged their currency risk.

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So if we go to their holdings,

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if we put their holdings together with the,

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forward contract, we can observe from the data.

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Indeed, they basically get rid

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of a hundred percent of the currency exposure.

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If they have euro denominate bonds, they will sell

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and buy USD using follow contract.

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If they have British fund denominate bonds,

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they would sell British funds and buy USD.

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So everything is almost a hundred percent fully hatched

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outside of those fully hatched mutual funds.

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The rest of the funds do a little bit of everything.

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There are some funds that will partially

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hedge their exposure.

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Like for example, if they have a dollar worth

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of foreign currency exposure,

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on average they'll hedge like 20% of

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that 20 cents on a dollar, right?

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Some of the funds will selectively hedge some currency,

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but not others, even though they have holdings denominated

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across all those currencies.

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So that sort of, indicate to us

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that they have certain view on

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how those currencies will appreciate

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or depreciate, depreciate against USD in the future.

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And some other funds we find will even enter into those four

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contracts, not to hedge themselves,

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but to sell US dollars exchange for foreign currency.

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So they are increasing their current exposure instead

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of hashing them using forwards.

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That can happen if they think that, relative

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to buying the underlying bonds, if the bond market in

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that country is not that liquid, sometimes,

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enter into those forward contract

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to get the four increased exposure might be more,

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economic or cost effective than buying the bond,

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the underlying asset.

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I think the number of things I think are interesting, right?

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One thing is that if you zoom out a little bit,

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to think about those mutual bond, mutual, those,

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international bond mutual fund in the context

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of the industrial competition

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or industry organization of mutual fund industry,

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you can see that fund managers

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or mutual fund sometimes choose their hatching strategy

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based on their competition,

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based on their relative ranking within other,

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in relation to other mutual funds doing similar stuff.

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For example, in this bond mutual fund, context,

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mutual fund managers are worried

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to more about outflows having poor performance

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and investors withdrawing their capital,

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so outflow from mutual funds

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rather than achieving good performance

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and attracting inflows.

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And the reason is that this is fixed income.

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So like your upside is somewhat limited.

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You can't really have a against your quarter

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and track of inflows.

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You can maintain a steady performance

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and get your, maintain your money,

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but then it's relatively riskier

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or easier to have a very poor quarter.

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And then all the investors worrying about their,

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liquidity withdraw money.

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And that could be a problem for the fixed income managers

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because the holdings are relatively illiquid.

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So if they have large redemptions, they have to worry about

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how am I going to get enough cash

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and whether liquidating my position creates more

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performance down the road.

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So when a mutual funds the international fixed income funds

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that we're talking about, when they have experienced

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relatively poor performance in the recent quarters,

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they tend to hedge more, right?

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They tend to get rid of the downside risk

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and avoid being in the bottom percentile

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of their peer funds.

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I think that's quite interesting.

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And the other thing about this industry organization is

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that, it also matters who are the clients

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and investors of mutual funds.

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What we find is that for mutual funds who are primarily sold

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to retail investor, they tend to hedge more.

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And if they are primary sold to institutional investor,

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they tend to hedge less.

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And we think it makes sense

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because retail investors don't have their means

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and abilities to hedge currency risks on their own end.

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So it makes sense to offer a product

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that's almost fully hatched

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to those retails versus institutions.

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If they, to extend that they invest in a mutual fund,

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it perhaps is a part of a bigger portfolio,

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and this institution might have a

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currency desk on their own.

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So maybe the current risks are managed,

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in a more centralized way.

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So in that word, they don't need the mutual fund

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to do the hedging work for them,

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the decisions made elsewhere.

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We find that to be a interesting question

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because, like theoretically

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or the answer to that question is not that good.

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Um, so on the theoretical side,

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there has been some past studies using like simulated data,

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but then the, his, the correlation matrix

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between assets are from historical data, right?

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So a style as fact is that historically for fixed income

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for bonds, their return is somewhat uncorrelated

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with currency returns.

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And if you have an asset where its return is uncorrelated

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with currency returns

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and you want to, put together a

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mean variance optimum portfolio, the the way

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to do it is to fully hedge.

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So there's some theoretical suggestion that,

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we investors should fully hedge their, their current risk

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or fully hedge currently risk should,

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improve the sharp ratio the unit

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of return investors can achieve per unit of risk.

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Uh, but on the other hand, if you go outside of

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that theoretical or simulation practice

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in real world hatching those current exposures

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00:11:33.785 --> 00:11:35.705
through forwards and other derivatives,

255
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they involve transaction cost, right?

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00:11:37.565 --> 00:11:40.185
But the forwards we're talking about, the,

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the mutual fund had to roll over this forward contract every

258
00:11:43.585 --> 00:11:46.105
two or three months, and that can be costly.

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00:11:46.845 --> 00:11:49.585
And for some mutual funds who do not fully hedge

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but selectively hedge, there are some room for them to

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00:11:53.645 --> 00:11:55.925
actually enhance, potentially enhance their return

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00:11:55.925 --> 00:11:57.285
through selectively hedge

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00:11:57.555 --> 00:12:00.685
because for example, some studies show that,

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currency have momentum.

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00:12:02.325 --> 00:12:06.525
Meaning if a, for example, if British Fund has

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recently appreciated against US dollars, then historical,

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00:12:10.685 --> 00:12:13.025
track record suggests they might continue

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to appreciate again US dollar.

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00:12:14.565 --> 00:12:17.825
So if you, if a mutual fund has some flexibility in

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00:12:17.985 --> 00:12:19.625
choosing what to hedge and what not to hedge,

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00:12:19.625 --> 00:12:22.505
they may choose to dial down their hedging

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of British pounds, for example, if they have performed well.

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00:12:25.485 --> 00:12:28.265
So they, the idea is that if they continue to perform well,

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00:12:28.565 --> 00:12:30.025
that's add into if you,

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00:12:30.085 --> 00:12:32.145
and you choose not to hedge British fund

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00:12:32.255 --> 00:12:34.385
that actually contribute to the performance.

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00:12:34.765 --> 00:12:36.985
So there is some ambiguity

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00:12:37.215 --> 00:12:40.345
that in reality whether a fully hatched mutual fund would

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00:12:40.345 --> 00:12:44.185
have performed better than a unhatched

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00:12:44.185 --> 00:12:45.945
or selectively hatched mutual funds.

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00:12:46.085 --> 00:12:47.345
So we take that into data

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and our sample period is from 2010 to 2018.

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00:12:52.045 --> 00:12:53.665
Um, and in our sample

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00:12:53.765 --> 00:12:56.905
of US Dollar South International Fixed Income Fund,

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00:12:57.405 --> 00:12:59.505
we do find that fully hedge fund tend

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00:12:59.605 --> 00:13:03.585
to perform better in ti in terms of their,

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00:13:03.895 --> 00:13:07.705
rate return and the reduced about 50%

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00:13:07.725 --> 00:13:09.065
of the return volatility.

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00:13:09.165 --> 00:13:11.625
So you get slightly better return, but half the risk.

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00:13:12.005 --> 00:13:16.465
So from a standpoint of, of achieving the highest level

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00:13:16.465 --> 00:13:18.785
of return per unit of risk you're taking

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00:13:19.405 --> 00:13:22.345
in our sample period seems like fully hedge fund,

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00:13:22.345 --> 00:13:23.665
they came up on top.

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00:13:24.005 --> 00:13:26.905
We do want to caveat that this time period,

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00:13:26.905 --> 00:13:30.065
this decade from 10 point 10 to roughly 2018,

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00:13:30.255 --> 00:13:33.185
that is there has been a period where US dollar,

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00:13:33.725 --> 00:13:34.865
performed well.

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00:13:34.865 --> 00:13:35.865
They have strengthened

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00:13:36.285 --> 00:13:38.945
and there are certain, issues in the Euro market.

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00:13:39.125 --> 00:13:43.225
So perhaps, this realized return is not indicative

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00:13:43.365 --> 00:13:45.305
of the expected return.

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00:13:45.765 --> 00:13:48.585
But still with caution, I will still suggest

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that currency hedge seems to be a good deal for investors,

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00:13:52.035 --> 00:13:55.465
especially for those who, are domiciled in us

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00:13:55.525 --> 00:13:58.425
and who care about the consumption in terms of US dollars.

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Currency Management by International Fixed-Income Mutual Funds

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