Mutual Fund Performance and Embedded Currency Risk

Abstract:     
We document a puzzle that the embedded currency risk in the international mutual fund industry, defined as the currency volatility risk and crisis risk of the benchmark traced by a fund with respect to the base currency of the fund, negatively affects equity selection and fund performance. The puzzle implies that benchmarking and the limits to derivative use may jointly induce fund managers to engage in operational hedge by adjusting the currency weights of its equity portfolio, which distorts equity selection and reduces fund performance. We test three possible operational hedge policies for a complete worldwide sample of international mutual funds: investment weight in the base currency, currency concentration, and currency herding with other fund managers. Our empirical analyses suggest that funds mainly use currency concentration to manage currency risk, and that funds with more concentrated currency portfolios deliver an annualized performance 100–200 basis points lower than those with a less concentrated portfolio.

Number of Pages in PDF File: 53

Keywords: mutual fund, currency risk, portfolio management

JEL Classification: G23, G30, G32

working papers series