Currency-Hedged Equity Funds: Performance and Fund Flows

Abstract

We analyze how currency hedging affects the measured performance of currency-hedged equity funds and estimate the impact of the return contribution of currency hedging on their fund flows. Measuring fund manager skill based on common factor models, the factors should capture returns of known strategies, e.g. investing in value stocks. However, currency hedging activities of currency-hedged funds are not captured by common factor models. By introducing a currency hedging return factor, we show how to account for the hedging of these funds in factor models, which helps to generate a more reasonable alpha. In our empirical analyses, we use a sample of ”twin share classes” of funds that invest in the same underlying portfolio but differ in terms of their hedging behavior: One has a currency hedging designation and the other one does not. We show that the introduced factor captures returns from currency hedging. Studying the impact of performance on fund flows, we decompose the return of currency-hedged funds into different parts. Our results indicate that the return contribution of currency hedging drives fund flows in addition to management skill.

Keywords: factor models, currency hedging, fund flows, mutual funds

JEL Classification: G11, G12, G23