Developing an effective currency attribution framework

There are a growing number of asset owners taking a centralized approach when managing their increasing exposure to currency fluctuations with a currency overlay program. 

This has, in turn, driven the necessitation for a framework that allows asset owners to evaluate the added value of decisions in such programs to the fund’s total return. How can asset owners effectively develop such a framework?

How does currency attribution differ to market decision-based attribution?

The fundamental differences between currency overlay and market investment decision process (IDP) stem from the unique nature of currencies, which are typically hedged to some extent. The resulting challenge can be addressed by constructing benchmarks within the currency overlay attribution frameworks that reflect specific currency decisions in an appropriate way.

Defining a benchmark to represent the currency strategy

Any currency overlay program is designed around the asset owner’s strategy regarding foreign currency exposure. This will be driven by internal decisions around levels of risk and return, as well as available expertise.

Some funds prefer to have no exposure at all, whereas the other extreme is to allow for exposure across all foreign currencies. Most funds are somewhere in between, from accepting some threshold exposure to major currencies to having currency exposures in line with their market SAA’s currency allocation.

For a currency overlay benchmark to be useful and serve as the starting point for any attribution, it needs to align with this strategy. The key to a meaningful currency overlay benchmark lies in determining the amount of currency exposure to be hedged. Think of this as the ‘to-do list’ for the currency overlay manager. The benchmark will always be a function of hedging certain currencies for a certain percentage relative to:

• currency exposure implied by the benchmark, or
• the total fund value

While this benchmark focusses on the amount of currency exposure to be hedged, you also need a return per currency. For this purpose, a so-called virtual hedge return is appropriate. The most common method to calculate these returns is by using the return on three-month forward contracts rolled over daily for every currency. Variations in duration and rebalancing used can be applied, if this is done consistently for all currencies in the benchmark.

Developing currency overlay benchmarks to measure allocation decisions

Once the strategy and exposures to be hedged have been set accordingly, the actual currency overlay program comes into play. This usually starts with one or more allocation decisions. One of these decisions can be to proxy some foreign currencies with another currency due to liquidity constraints and/or cost effectiveness. Also rebalancing frequency in the currency overlay program might differ from the one in the strategic benchmark.

Finally, the currency overlay managers might have a mandate to deviate from the strategic amount of currency exposure due to short-term outlooks. All these decisions will impact the returns generated via the currency overlay program. To separate their added value, these allocation decisions should be divided into consecutive steps, with the currency exposure in the final step matching the actual hedged exposure. The added value from these decisions can then be measured by using a benchmark with an ‘adjusted’ amount to be hedged, where each benchmark is then compared to the ideal adjusted value.

Benchmarking the implementation decisions

Once the strategic and tactical allocation layers have been covered, the final decision layer represents the actual implementation of currency hedges. For this purpose the benchmarks used must use the actual hedge return, rather than a virtual hedge return employed in the strategic and tactical decision layer. The returns will differ between the two because decisions made in this layer, such as those related to maturities, rollover strategy, and instrument choice, do not exactly replicate the virtual hedge return.

Developing benchmarks with this approach allows the added value of decisions in this layer to be fully attributed to the difference in hedge return.

Combining the results with market decision-based attribution – the final step

When a currency strategy and currency overlay program are in place, it makes sense to reflect this in the decision attribution of the market decisions. This can be done by applying the virtual hedge returns per currency to the market returns – both in the portfolio and benchmark – to get a true value add from your managers. This approach also allows you to evaluate the fund performance without any hedging versus the performance including the strategic hedge.

Next step is to add the added value of the currency overlay program. This tells you how effectively the strategic hedge was implemented and any additional value added by the currency overlay decisions.

These two combined give you a full breakdown of the total fund excess return. But be mindful; when you combine the market attribution results with the decision-attribution from the currency overlay program, you must adjust for the ‘double counting’ when tallying the returns of both frameworks.

Want to learn more about currency attribution frameworks?

To learn more about how to practically setup a currency attribution framework that recognizes the differences from market IDP attribution while allowing results from both analyses to be combined, download our whitepaper ‘Currency overlay attribution: A practical guide’ or learn more about our currency overlay attribution capabilities within our established performance measurement and attribution solution – PEARL.

Performance measurement and attribution  PEARL’s currency overlay attribution