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GLOBAL MACRO & CURRENCY MANAGEMENT

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CURRENCY OVERLAY

Institutional Currency Overlay Services

Currency overlay generally refers to the separate management of currency risks embedded in a global investment portfolio (also known as the underlying portfolio, which can be in any or several asset classes, e.g. fixed income, equities, alternatives, etc.). Currency overlay is used to separate currency risk from the risk of the underlying asset classes, centralise the currency risks in the underlying portfolio(s) and manage them effectively and efficiently. The two principal strategies, depending on a client’s core objectives, are referred to as being either "passive” or "active”.

The global trend of increasing asset allocations to overseas investing is firmly entrenched. This requires careful management to ensure that returns on overseas assets are not diminished or engulfed by adverse currency moves.

Generally speaking, unmanaged currency risk in an internationally invested portfolio is a source of uncompensated volatility. For that reason, ECU recommends that investors consider hedging their foreign currency exposures. Currency fluctuation accounts for a significant portion of portfolio risks (roughly 85% of an international developed markets bond portfolio’s volatility can be attributed to currency risk, and roughly 25% of an international developed markets equity portfolio’s volatility can be attributed to currency risk).

Total portfolio returns = return on underlying FX

FX risk:  approximately 25% for global equities and 85% for global bonds (Source: ECU and SLJ)
 
FX risks typically result from country allocation and/or stock selection in a global portfolio
FX Overlay to Manage Currency Risks
Currency market: although the most liquid of markets it also exhibits inefficiencies

Different market participants have different investment motives which are not all related to profit (central banks, corporates, private individuals)

Currency management: opportunity to both reduce risk (passive) and enhance return (active)

Opportunities for both Institutional and Wealth Management segments

 Over the long term (5-10 years), the expected return to foreign currency may be inconsequential or even zero, but its contribution to total portfolio volatility can be significant. Over shorter periods, currency movements can be large. The change in exchange rates may work in favour of or against an investor. But over the long run, even positive return contributions are often outweighed by significant increases in overall portfolio volatility, resulting in lower portfolio information and Sharpe ratios.

Separate management of currency risk, whether through a passive or active hedge, also promotes transparency and can add value. Equity or fixed income managers, for example, are held responsible for investment decisions within their area of expertise, and a specialist currency manager is held responsible for currency allocation decisions. The source of returns, whether they are generated from the underlying asset classes or from currency positions, becomes much more transparent.

"Passive" Currency Overlay

Passive currency overlay programmes are designed to reduce, or remove entirely, currency risk from an internationally invested portfolio. Clients can choose to remove any fixed percentage of a portfolio’s currency exposure through a tailored hedging programme. Our FX Overlay team is tasked with monitoring our clients’ currency exposures as they evolve over time, and ensuring that the hedge ratio is maintained close to the target level, whilst reducing operational risk and minimising transaction cost drag.

The objectives for the client under a passive overlay programme should be twofold. Firstly, seeking to achieve local market investment returns from the underlying assets, less the costs associated with the hedging program and, secondly, lowering portfolio volatility, achieved by reducing or removing unwanted currency risk. Accordingly, clients can partially or fully protect themselves from foreign currency volatility and depreciation, but forego the opportunity to participate in any foreign currency appreciation.

"Active" Currency Overlay

The main objective of active currency overlay programmes is to manage currency risk in order to add value to the overall portfolio. Our investment methodology for all active overlay mandates combines academic and analytical rigour, along with discretionary macro analysis and state-of-the-art proprietary models, offering an eclectic combination of top-down and bottom-up processes. ECU’s FX Overlay team seeks to increase the hedge ratio applied to currencies that are expected to depreciate, thus protecting clients from an adverse move in those currencies, while reducing the hedge ratio applied to currencies that are expected to appreciate, allowing clients to benefit from exposure to those currencies in the event they then appreciate.

The main attributes of active currency overlay programmes are threefold:

Firstly, exposure to currency risks in a portfolio is monitored, managed and controlled so that currency management decisions can be segregated from investment decisions appertaining to the underlying asset classes in their respective geographical locations.

Secondly, by employing a specialist Currency Overlay team to manage the currency risk, investment managers can focus entirely on underlying investment decisions in local currency, whilst the ultimate investment portfolio achieves a clear segregation of the currency risk from the underlying investment risk (itself achieving an often preferred diversification of manager risk).

Finally, within a fund or large portfolio structure, administrative functions (such as the monitoring of overall currency exposures, hedging policy and performance reporting) can be centralised at a higher level. This is particularly valuable for investors who have made allocations to several different fund managers or funds.

Our active overlay services, which we provide in association with our strategic partners, SLJ Macro Partners LLP, can be tailored to the specific needs of each individual client depending on risk preferences and other investment requirements.


Passive Overlay
Risk Management
Active Overlay
Risk Management
Objective
  • Significantly reduces volatility of international investment portfolios
  • Replaces "random volatility" with managed risk
Risk
  • Removes all currency risk (if 100% hedged)
  • Removes currency risk where manager forecasts currency depreciation
  • Leaves currency risk unhedged where manager forecasts currency appreciation
  • Does not increase currency exposure beyond that of the underlying portfolio (no leverage, no net shorts)
Return
  • Portfolio earns local currency returns from international investments (less hedging costs)
  • Portfolio will not participate in foreign currency appreciation, nor will it suffer from foreign currency depreciation (if 100% hedged)
  • Portfolio earns hedged returns from international investments PLUS active returns from active currency overlay
  • Portfolio may participate in foreign currency appreciation and may be protected from foreign currency depreciation—if the currency manager makes the right calls!

More Information 

For more information on ECU’s active currency hedging solutions, please contact Michael Petley, Chief Investment Officer.

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