Paying the price for currency hedging

This Bronze-rated Franklin fund still has an edge that stems from a seasoned management team and a proven multiasset approach.

Jeffrey Bunce, CFA 6 September, 2016 | 5:00PM
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 Franklin Mutual Global Discovery earns a Morningstar Analyst Rating of Bronze for its seasoned management team and integrated value approach. However, detrimental currency hedging and lacklustre recent performance temper our conviction.

Management's bottom-up approach is primarily oriented toward cheap stocks but also includes distressed debt and merger-arbitrage opportunities. Focusing on fundamentals helps them look past short-term drops and buy more when they think a security has become a bigger bargain. In addition, a thorough evaluation of a firm’s capital structure helps them identify the best return opportunities.

A hallmark of the fund has been its cautious approach, which the managers continue to employ. The team pays close attention to downside risk when selecting stocks. Diversification is also key. Because it is tough to judge the timing of turnarounds, management spreads its bets across 135 stock and bond holdings.

The managers elect to hedge a majority of the fund's non-Canadian currency exposure. Recently, the choice to hedge back to Canadian dollars has cost the fund as Canada's currency has significantly depreciated against other major currencies. Indeed, since lead manager Peter Langerman began his second stint on the fund at year-end 2009, its 6.7% annualized gain through June 2016 trails the typical global-equity category rival's 8.3% return and the MSCI World Index's 12.0% return.

The 2015 calendar year was particularly painful as the fund lost 1.4% and trailed the unhedged MSCI World by over 20 percentage points. A bit more than half that underperformance was due to currency hedging. The rest mainly related to stock selection. The managers built a top-25 position in Volkswagen by midyear because they thought its stock price didn't reflect the value of its Porsche and Audi businesses. When the firm’s share price subsequently got crushed following its emissions scandal, management reassessed the company's value including all possible fines and lost sales and bought more, convinced the market reaction was overdone.

The fund still has an edge that stems from a seasoned management team and a proven multiasset approach. Management aims to layer downside protection into the structure of the portfolio. It holds a diverse mix of roughly 130 equity and fixed-income securities. Value-oriented stocks typically take up 80% to 85% of the fund's assets, while the remainder is split between cash, distressed debt, and merger-arbitrage positions where implementable and as opportunity dictates. As of June 2016, the fund's equity stake stood at about 88%, with roughly 4% of assets in distressed debt and 8% in cash. Since bankruptcy plays, whether liquidations or reorganizations, move according to the courts' timing, they can reward investors independent of market movements. Yet, they also come with their own brand of uncertainty.

This fund was a strong performer during the credit crisis in 2007 and 2008 primarily because of the previous managers moving its cash weighting to 50%. This cash position was a combination of a market call and the managers being unable to find attractive positions. While it helped performance, investors should not consider this the norm. Cash was near 30% when the current team took over in late 2009. It quickly came down and has since ranged from roughly 5% to 15%.

The fund has the flexibility to invest across regions including the United States, international developed markets, and up to 25% in emerging markets. However, the fund has historically kept emerging markets exposure under 5%, and it was roughly 4% as of June 2016. U.S. stock exposure hit its trough of 14% in early 2008, but since then it has risen as a percentage of equities and now sits at 56%. This is still less than the 60% allocated to the U.S. in the MSCI World Index but greater than the 53% for the global-equity category average.

Rather than hedge the currency of a stock's domicile, the team analyzes the currency makeup of each stock's revenue to arrive at a hedge ratio. This ratio has fluctuated over time between approximately 50% and 85%. In 2015, the team hedged between 75% and 85% of the fund's non-Canadian dollar exposure back to Canadian dollars.

Part of the reason for the performance struggles relates to the fund's currency hedging. A greater than 20% decline in the Canadian dollar versus the U.S. dollar since the start of 2013 (including a significant fall in 2015) has been a challenge for the fund as it hedged away most of those gains. The Canadian dollar has suffered similarly against other currencies, too. The managers' rationale for hedging is to reduce volatility and provide downside protection but the result over the past six and a half years has been the opposite--namely a standard deviation greater than the MSCI World and a downside-capture ratio over 100%--resulting in mediocre risk-adjusted returns. Periods of Canadian dollar strength, though, should help performance but not necessarily limit volatility.

The fund's class A shares have a management expense ratio of 2.60%. This is down from 2.77% in 2011 but is still slightly ahead of the commissioned-based category median of 2.55%. The class F shares cost 1.45% and are similarly slightly more expensive relative to the fee-based category median of 1.34%.

Because of the fund's long-term focus, portfolio turnover stays fairly low, which keeps trading costs generally below average. On a total cost basis, this helps improve the positioning of the fund. Overall, though, the fund still ranks in the middle of the pack on fees.

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About Author

Jeffrey Bunce, CFA

Jeffrey Bunce, CFA  Jeffrey Bunce, CFA, is a senior investment analyst for Morningstar’s Investment Management group.

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