As more asset owners adopt centralised currency overlay programmes to manage growing foreign exchange exposures, the need for a robust framework to measure the added value of these decisions has become critical. Such frameworks help evaluate the contribution of currency strategies to overall fund performance—an essential step as currency volatility increasingly impacts portfolio returns.
Ortec Finance, a global technology and solutions provider for risk and return management, recently offered guiddance on how to develop an effective currency attribution framework.
Currency attribution differs significantly from traditional market-based decision attribution. This is primarily because currency positions are typically hedged, which makes it harder to isolate performance impact. To address this, attribution models need to include currency-specific benchmarks that fairly reflect strategic and tactical decisions made within the overlay framework, it said.
The design of any currency overlay benchmark must reflect the asset owner’s approach to foreign currency exposure. This is typically influenced by internal views on risk, return, and available resources. Some funds choose to eliminate foreign currency exposure altogether, while others accept varying degrees of exposure aligned with their strategic asset allocation (SAA). For the benchmark to be meaningful, it must mirror these strategic choices and specify the proportion of each currency exposure to be hedged—either relative to the benchmark-implied exposure or the total fund value.
To calculate returns per currency, a “virtual hedge return” is commonly used, Ortec explained. This is typically based on the return of three-month forward contracts that are rolled over daily. While duration and rebalancing methods may vary, consistency across all currencies in the benchmark is crucial.
Once the strategy and exposure targets are set, the next step involves executing the overlay programme. This begins with a series of allocation decisions. For instance, a manager may decide to proxy less liquid currencies with more liquid alternatives or adjust rebalancing frequencies to reduce costs.
The final layer concerns the implementation of the currency hedges. At this stage, it is important to move from virtual hedge returns to actual hedge returns, as real-world execution decisions—such as the choice of instruments, contract durations, and rollover strategies—may lead to differences in outcome.
The final step is to combine currency attribution with the broader market decision attribution framework. By applying virtual hedge returns to both the portfolio and benchmark returns, asset owners can assess the added value of fund managers without the influence of currency hedging.
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