A new study of share class hedge returns conducted by Lumint Corporation and New Change FX (NCFX) reveals significant underperformance of hedged share classes. FX hedging could be costing the UK investment industry up to $5 billion per year. This cost acts like an indirect tax on the end consumer – the pensioner. Furthermore, this cost is undisclosed.
FX share class hedging is routine and mechanical and thus frequently overlooked. But the numbers demand attention.
The chart below from the Lumint/NCFX report shows a summary of the hedged share class performance (in green), relative to the un-hedged master share class (blue). In aggregate, share class hedging over the period acted as a consistent and cumulative drag.
The report finds that “The performance pattern is clearly offset by a cumulative drag over time on the Hedged Share Classes. This indicates that the costs incurred are structural and significant over time.”
FX Execution Costs
After adjusting the gross performance differential between hedged and unhedged classes, we find the following costs that are attributable to FX execution costs:
|Fund Type||Annualised Gross Performance Difference||Annualised Cost of Trading|
Source: NCFX/Lumint Corporation
Putting these costs into perspective
Average FX implementation costs are 0.42% per annum. The Lumint/NCFX report finds “Where we have been able to identify Assets Under Management (19 out of 28 managers) we find a total trading volume of USD 1.6 trillion over almost three years at a cost of USD 432 million for the period. This equates to an average cost per million dollars traded of USD 267.”
New Change FX conducts transaction cost analysis for many comparable global asset management firms and we find the average cost of FX swap rolls is $35 per million or approximately ⅛th the cost. One salient difference between samples is that the $267 per million group do not break out their FX implementation costs, while the control group have hired New Change FX to conduct forensic transaction cost analysis (TCA) against independent benchmark data.
The report further states “The UK asset management industry’s assets are approximately USD 10 trillion . If we assume that 24% of them are invested overseas, as per the ratio of domestic to hedged foreign investment identified here (based on Investment Association numbers) , then the annual cost from trading is in excess of USD 5 billion per annum.
Given the low return environment, sub-optimal FX hedging is potentially costing investors a large portion of their returns.”
We say potentially because the 0.42% per annum is an average, and the dispersion is high. Although some share class hedging programs are being implemented at low cost the majority are clearly incurring very high costs.
 INVESTMENT MANAGEMENT IN THE UK 2018-2019 – The Investment Association
What should you do?
Given the scale of the problem it is vital investors understand the cost of FX hedging of any share class they are invested in.
A fundamental requirement of this control is that TCA should be undertaken by an independent entity, and measured against independent data, rather than be just a box ticking exercise that may have incentives to distort transaction cost results.
TCA that is conducted by a business that directly or indirectly benefits from executing transactions generates a clear conflict of interest. Asking participants who benefit financially from the client’s business to measure costs can result in compromised control information.
Where New Change FX comes in
New Change FX is a regulated Benchmark Administrator and publishes the NCFX mid-rate benchmarks for FX Spot and Forwards. In addition, New Change FX is a leading TCA provider, with a range of tools and services to help asset managers and asset owners around the world manage their FX costs. New Change FX is completely independent. We do not offer any execution services and have no incentive or ability to hide FX costs. When done well, TCA can highlight operational inefficiencies, that once corrected, can significantly reduce friction costs, contributing to better net performance.
We all need to start saving money for our retirement. This can be as simple as not frittering away the money we do have unnecessarily.