The impact of currency on returns and portfolio performance

Under global market conditions, where uncertainty continues to escalate due to a range of factors, including President Trump’s recent trade policy rollouts, asset owners are seeking to manage their portfolios’ volatility and exposure to a broad set of risks, including currency risk.

Currency risk is often treated as a secondary consideration in typical investment approaches, as it does not carry a risk premium. However, for large scale portfolios that include significant investments in assets not denominated in their base currency, any exchange rate movements can materially impact returns. From an asset owner’s perspective, this volatility warrants closer examination of how currency decisions (such as hedging activities) affect performance, and greater efforts to manage its associated risks.

Factoring in currency within investment decisions

The steps required to enable a closer analysis of how currency impacts returns will depend on how an asset owner currently manages currency decisions within their investment decision-making process. Asset owners generally adopt one of two currency decision frameworks, reflecting either a centralized or a decentralized approach:

1. Centralized approach: Currency exposure is integrated directly into investment strategies, with portfolio managers managing currency as part of their market allocation decisions. 
2. Decentralized approach: Currency decisions are made on top of investment strategies are separated from market allocation decisions made by portfolio managers, often through a currency overlay program. 

A centralized approach will require an analysis to determine the impact of currency decisions on total active return, whereas a decentralized approach will need to focus on assessing the added value of decisions within the overlay implementation as part of the fund’s total return.

Measuring currency decisions under a centralized approach

When currency decisions are made under a centralized approach, asset owners should seek to understand the impact of currency on their portfolio’s total return. This can be achieved by comparing base currency returns that incorporate the effects of currency hedging on non-base currency investments, in order to identify allocation and selection effects. These returns should then be decomposed into their underlying sources to provide clearer insight into how individual currency hedging activities influenced portfolio performance.

Measuring currency decisions under a decentralized approach, such as an overlay program

When currency decisions are made under a decentralized approach at total fund level via an overlay program, asset owners should seek to understand the added value generated by the overlay implementation relative to policy within the total active return. This requires an currency overlay attribution analysis of the value added from decisions made under such programmes, measured against a suitable benchmark. In the context of currency, constructing a meaningful benchmark requires an adjusted approach that differs from market allocation benchmarks.

Managing currency decisions and risks under both approaches

Regardless of the chosen approach to managing currency, it is imperative for asset owners to understand how currency-related decisions are positively or negatively impacting their portfolio’s overall active return. By analyzing how decisions made by portfolio managers or within overlay programs contribute to performance, asset owners can refine investment strategies or adjust elements of the currency overlay program’s decision-making process accordingly.

Want to learn more about managing currency decisions?

Download our whitepaper - ‘The Currency Dimension’ to gain a deeper understanding how currency can be incorporated into performance measurement and attribution frameworks. For practical insights into analyzing currency decisions executed in an overlay program, we invite you to read our ‘Currency Overlay Attribution: A Practical Guide’.

Performance measurement and attribution  PEARL’s currency overlay attribution