The Impact of Currency Exposure on Institutional Investment Performance: The Good, the Bad, and the Ugly

Abstract

Institutional investor portfolios typically hold a significant allocation of foreign currency denominated assets. Very often at least some of this currency exposure has been viewed as bad or unwanted. On the other hand, recent studies have concluded that currency is itself an asset class that offers investors favorable risk-adjusted returns that could benefit a typical portfolio of stocks and bonds. There are two basic types of currency management mandates. In a currency hedging mandate (currency overlay), investors strive to manage (usually meaning reduce) the risk associated with the foreign currency exposure in their international assets. With an absolute return mandate (currency alpha), investors seek to earn a positive return subject to acceptable risk levels. The existing literature analyses these two basic types of currency management mandates separately. In this study, we investigate their impact on institutional investment performance simultaneously. We find that both absolute return and currency hedging mandates can have a positive impact on the portfolio risk/return characteristics. Absolute return mandates have the potential to increase the portfolio return with little impact on volatility. Risk reduction mandates tend to reduce portfolio volatility with little impact on returns. Due to the safe haven status of the U.S. Dollar, higher hedge ratios provide diversification for US dollar based investors when needed most, namely in periods of negative equity returns. Combining both currency hedging and absolute return mandates improves overall investment performance while allowing managers to stay within their portfolio risk budget.