The winners of the 2023 Hillsdale Investment Management – CFA Society Toronto Research Award are Wei Opie, Deakin University (Australia), and Steven J. Riddiough, University of Toronto, for their research paper entitled: On the Use of Currency Forwards: Evidence from International Equity Mutual Funds.

The award-judging panel noted that the paper “undertakes the first comprehensive investigation into the use of currency forwards at international equity mutual funds and finds that actively hedging can generate substantial investment outperformance. The panel selected the paper based on its high-quality writing, thoroughness of analysis, and findings that many finance professionals could readily apply.”

Chris Guthrie, CFA, CEO of Hillsdale Investment Management, commented, “I believe this paper is one of the first to seriously study currency hedging in the domain of equity mutual funds. Using hand-collected data, the paper documents important empirical patterns in how international equity mutual funds use currency derivatives for their diverse purposes and objectives. The paper identifies a link between the use of currency derivatives in the equity fund management industry and currency factor premiums such as carry and momentum.”

The researchers point out that, for over 30 years, investors have increasingly been seeking to diversify their wealth in foreign markets, with almost US$3 trillion now held in US international equity mutual funds, or 25 percent of the assets managed by the US equity mutual fund industry, up from 15 percent in the early 1990s. These foreign investments typically bring exchange rate exposure that could increase portfolio volatility and reduce investment returns. But, if managed well, exchange rate exposure can potentially be exploited to enhance a portfolio’s investment performance. The winning paper studies this critical issue of currency management at US international equity mutual funds, covering fifteen years to 2019, over 1,200 mutual funds, and over 55,000 net forward currency contracts.

Analyzing currency management in international equity mutual funds

The funds studied were internationally focused in their investment activity, with 83 percent of their assets, on average, issued by firms outside the United States. Moreover, G9 developed market firms issued 50 percent of the assets; hence, around one-third of assets were held in either small developed markets or emerging market countries. The funds typically held assets from a large set of countries, with funds investing in over sixteen different currencies, on average. They all had unhedged equity benchmarks and had no underlying mandate to hedge currency exposure.

Analyzing these data, the researchers contributed to the fund management literature by:

• Providing the first categorization of international equity mutual funds according to the way they use currency forwards
• Documenting the determinants of currency forward usage
• Investigating the impact of the use of currency forwards on fund performance
• Studying the relationship between currency-picking and stock-picking capabilities
• Exploring the investment performance implications for funds not using currency forwards

Opie and Riddiough found that 471 of the 1,279 funds (37 percent) were users of currency forwards during the sample period, with a user defined as any fund with an outstanding currency forward contract at the end of at least one quarter. They discovered that users tend to be older and more established and to have more assets under management, higher asset turnover ratios, smaller changes in funds under management, and slightly higher expense ratios.

US international equity mutual funds have adopted various approaches to managing currency exposure that the researchers have categorized into three distinct “styles” to capture the spirit of the different approaches to currency management they observed. The first category, which they labelled “exposure managers,” selectively engage in short-term currency forward contracts to reduce currency exposure and have non-trivial hedge ratios (hedge position as a percentage of total portfolio) above 25 percent, on average. The second group, labelled “portfolio builders,” have low hedge ratios (around 0 percent, on average) but typically high absolute forward positions (above 10 percent of their total net assets, on average). Thirdly, funds with low hedge ratios and absolute forward positions (close to 0 percent in each case) are classified as “occasional users.” These funds typically use currency forwards sporadically and in small quantities, likely for short-term liquidity needs, such as portfolio rebalancing.

Active engagement in currency hedging associated with outperformance

While many funds occasionally use currency forwards for short-term liquidity requirements, the majority adopts the foreign currency policy of “exposure management” or “portfolio building.” Exposure managers use currency forwards to reduce foreign exchange exposure, either to increase returns or to reduce volatility. In contrast, portfolio builders effectively construct a separate “dollar neutral” currency portfolio, taking long and short positions, frequently in currencies not within the underlying equity portfolio. In both cases, funds typically seek more exposure to currencies with higher interest rates, stronger short-term momentum, and lower volatility. However, the authors find that the current practices of currency forward users could potentially be enhanced. 

Interestingly, the paper documents that portfolio builders who generate the most robust currency investment performance also have the strongest performance in their equity portfolio, pointing to a potential new avenue for exploration in the literature on mutual fund performance.

Not using currency forwards may be “leaving money on the table”

Moreover, the study highlights that non-users could potentially leave “money on the table” by not incorporating currency forwards in their portfolios. This is suggested by the fact that, across the entire sample, both a fully hedged approach and a dynamic-currency-hedged approach (where the target hedge ratio varies based on exposure to predictable factors that are known to determine currency returns such as carry) would have delivered substantially higher risk-adjusted returns. 

Furthermore, while full hedging and dynamic hedging produced superior performance compared to not hedging during a period of US dollar appreciation from 2012 to 2019, dynamic hedging also had a similar level of performance to unhedged portfolios during a period of US dollar depreciation from 2004 to 2011. The researchers commented that understanding the extent to which not using currency forwards is an inefficient approach to currency management presents a potentially fruitful direction forward for both theoreticians and empiricists. 

The Hillsdale Investment Management – CFA Society Toronto Investment Research Award is open to researchers globally who conduct research related to Canadian capital markets, including both academics (e.g., professors and students) and practitioners. Author(s) of the winning research paper are awarded CA$10,000. Research papers are reviewed by a panel of CFA charterholding investment experts to ensure they align with the rigorous values and standards embodied in the CFA designation.