How currency attribution enhances performance analysis

Asset owners, such as pension funds and sovereign wealth funds, around the world are facing an increasingly complex landscape, shaped by sustainability concerns, short-term regulatory pressures, and geopolitical uncertainties. These factors can significantly influence a range of investment risks, including inflation, interest rates and currency volatility. 

In this complex environment currency movements show greater fluctuations which will have a significant impact on total portfolio returns.  The impact from currency movements is becoming more material, due to the ongoing diversification of portfolios across international markets, further compounded with higher allocations toward private assets. These investments often generate returns in currencies different from the asset owner’s base currency.

How are asset owners managing their exposure to currency fluctuations?

To help manage their increasing exposure to currency risk, a growing number of asset owners have implemented currency overlay programs. These programs utilize a range of derivative instruments such as forwards, swaps and options for the most prevalent currencies and are designed to help asset owners hedge against unexpected changes in currency exchange rates. The dynamic interactions between overlay strategies like this and other investment decisions often make these programs more complex than anticipated.

Analyzing currency overlay programs using attribution

Such currency overlay programs require performance attribution for asset owners to understand the value-add of individual currency hedging decisions. These can be strategic decisions like which currencies to hedge either completely or partly, tactical decisions related to proxies or short-term movements on currency markets and operational decisions related to roll-over timing and instrument selection.  An attribution analyses, similar to investment strategies for other asset classes and risk factors, should identify whether each decision underperformed or overperformed against expectations across these three key decision layers.

Does currency overlay attribution differ from other decision-based attribution models?

Performance attribution fundamentally requires a meaningful benchmark to allow asset owners to analyze the value added by individual decisions. While this principle applies to both currencies and other allocation decisions such as markets or asset classes, the key difference is how to construct a meaningful benchmark.

Decision-based attribution for asset classes traditionally utilizes market weights, a key benchmark indicator due to its risk premium, as outlined in the Karnosky and Singer framework. However, when applying market weights in the currency context, this approach presents challenges due to the unique nature of currencies, which are typically fully hedged or not hedged at all, neither of which is optimal for asset owners. Utilizing a form of hedged market weights is one option for asset owners to overcome these challenges and generate useful insights into the added value of their currency decisions.

How can asset owners construct meaningful benchmarks for hedging activities?

Hedged market weights can be developed by deriving returns from a strategic benchmark that consists of synthetically hedged foreign currency exposures. This approach requires distinguishing between actual currency exposure and strategic currency exposure, with a one or more tactical benchmarks positioned between these two figures.

Asset owners seeking to develop these type of benchmarks will need an attribution framework that allows flexibility to choose between base, local and virtually hedged currency returns. The framework should also provide the ability to model complex currency strategies that represent different steps of a hedging process.

Understanding currency decisions’ impact on the total portfolio returns

With currency movements continuing to be a significant factor affecting overall portfolio returns, it is imperative for asset owners to understand both how individual and overall currency decisions are positively or negatively impacting outcomes. By evaluating these decisions using an attribution framework, asset owners can assess if the hedging policy serves its purpose and adjust any layers in the decision-making process accordingly.

Want to learn more about currency overlay attribution?

To learn more about the difference in results when utilizing a strategic benchmark proxied from hedged foreign currency exposures, download our whitepaper - ‘The Currency Dimension’ or learn more about our currency overlay attribution capabilities within our established performance measurement and attribution solution – PEARL.

The Currency Dimension PEARL’s currency overlay attribution