As global markets continue to face volatility driven by shifting economic policies—including trade developments—asset owners are placing greater emphasis on understanding and mitigating currency risk.
Although often overlooked due to the absence of a clear risk premium, currency fluctuations can significantly affect the performance of global portfolios, especially those with large exposures to foreign assets.
Ortec Finance, a global technology and solutions provider for risk and return management, recently delved into the impact of currency on returns and portfolio performance.
The ability to assess the impact of currency on investment returns largely depends on how currency decisions are embedded within the investment process. Asset owners generally use either a centralised or decentralised framework for currency decision-making.
In a centralised model, currency exposure is incorporated into portfolio strategy itself. Portfolio managers manage currency as part of their overall market allocation decisions. In contrast, the decentralised model separates currency decisions from investment strategy, typically handled via a currency overlay programme.
Each approach requires a different measurement focus. In centralised strategies, asset owners must evaluate how currency decisions contribute to total active return. In decentralised setups, the emphasis shifts to the value added by the currency overlay relative to policy benchmarks, as part of the total return.
When using a centralised approach, asset owners should focus on identifying the impact of currency exposure on total return, Ortec stated. This involves calculating base currency returns that reflect the effects of hedging activities on non-base currency assets. These returns can then be decomposed to isolate allocation and selection effects, offering insight into how individual currency decisions have influenced overall performance.
In decentralised models where currency exposure is managed through an overlay, asset owners need to evaluate the value added by that overlay compared to policy, it said. This is achieved through a currency overlay attribution analysis, which measures performance against a customised benchmark. Given the nature of currency management, such benchmarks often require specific adjustments distinct from those used in broader market allocations.
Regardless of the framework in place, it is vital for asset owners to understand how currency decisions affect total active return—positively or negatively. By evaluating how these decisions contribute to performance, whether through direct market strategies or overlay programmes, asset owners can refine investment processes or adjust currency management policies accordingly.
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