Considerations for Multi‑Currency Portfolios

Overview

I remember the first time I managed a portfolio that invested in several different countries. I felt pretty confident about the fundamentals of each stock and bond I’d chosen. But then—bam—the portfolio’s performance in our base currency was all over the place, even though local returns looked stellar. It was a humbling moment, and it quickly taught me how currency fluctuations can make, or break, a carefully constructed multi-asset strategy. Anyway, in this section, we’ll dive into the nitty-gritty of how currency exposure affects portfolio performance measurement, how to attribute returns across multiple currencies, and how to report results in a consistent fashion that won’t leave anyone confused.

Currency Effects in Performance Measurement

Let’s start with a simple truth: whenever you hold assets denominated in a currency that’s not your base currency, your total return will partly come from the price changes in the underlying asset and partly from exchange rate movements. The standard formula to convert local asset returns into your base currency might look like this (and it’s slightly mathy, but bear with me):

$$ R_{\text{base}} = (1 + R_{\text{local}}) \times (1 + R_{\text{FX}}) - 1 $$

Here,
• \(R_{\text{base}}\) is your total return in the base currency,
• \(R_{\text{local}}\) is the asset’s local currency return, and
• \(R_{\text{FX}}\) is the currency return (essentially the percentage change in the exchange rate).

Perhaps you bought a Japanese equity that returned 5% in yen terms, but your base currency is USD. If the yen weakened by 2% against the USD in that period, that currency movement would reduce your total return in USD. And that’s sort of a simplified illustration of how big a deal currency can be. Even if the underlying asset does great in local terms, currency depreciation can wipe out much of those gains.

Hedging vs. Non-Hedging Decision

Managing currency risk can be done passively or actively. A passive currency hedge involves offsetting currency exposures systematically—think using forward contracts to lock in exchange rates. In contrast, active hedging (or active currency management) attempts to generate alpha through strategic decisions about when and how much to hedge. Both choices significantly influence your total returns, so measuring currency effects accurately is vital for evaluating whether these hedging strategies are adding value.

Example

Let’s say you have EUR-denominated bonds in your portfolio. You’re a USD-based investor. You decide to hedge 50% of your euro exposure. If the euro depreciates 4% against the dollar, the half that’s unhedged sees a 4% currency loss, but the hedged portion is largely protected (ignoring any minor costs and slippages). When you measure performance, therefore, you need to break out how much of your total return came from the bond’s intrinsic performance in euros, how much from currency moves (both hedged and unhedged portions), and how much from your hedging costs or gains.

Attribution Approaches

Performance attribution in multi-currency portfolios can get tricky, but it typically breaks down into three main pieces:

1. Local Market Return: How well did the security perform in its own currency?
2. Currency Allocation Effect: How was the overall return impacted by holding certain currency exposures (or hedging them)?
3. Security Selection Effect: Even for international equities, part of the difference in performance across stocks may come from the underlying currency’s strength or weakness.

Currency Allocation Effect

This effect refers to the incremental return that arises purely because of the currency exposures you chose relative to your benchmark. For instance, if your benchmark has 40% USD, 30% EUR, 20% JPY, and 10% GBP, but your actual portfolio has 60% USD, 10% EUR, 20% JPY, and 10% GBP, you can bet the currency allocation effect will be front and center in explaining performance difference. If the dollar outperforms the other currencies, your overweight in USD is likely to help the portfolio.

FX Impact on Security Selection

Sometimes it’s hard to separate currency from the local asset performance, especially if those returns are closely correlated with exchange rates or driven partly by capital flows from abroad. However, you can try to isolate the currency impact by examining how a security’s performance in local terms converts to the same security’s performance in your base currency. For example, if a stock soared 10% in local terms but the currency fell 9%, the net contribution to your base-currency-based performance might be only around 0.1%. That’s a big difference from the local perspective where 10% sounded fantastic.

Hedging Policy

Many managers directly incorporate currency decisions into overall asset allocation, while others use a currency overlay—a specialized manager or an internal strategy that deals only with currency exposures, separate from the underlying assets. In performance attribution, you can measure how much the hedging strategy (passive vs. active) contributed to active returns. If, for example, your active currency bets netted an extra 2% return over the year, that 2% is credited to the currency overlay or currency management decisions.

Multi-Currency Reporting

Consolidated reporting is a must for investors who want an overall snapshot of the portfolio, but it introduces complexities. You need a single base currency to present the entire portfolio’s performance, even if it holds assets in USD, EUR, JPY, and a few emerging market currencies. If you’re not careful, you might double count or misrepresent how much of a security’s return came from local fundamentals versus exchange rate movements.

Take a look at the following diagram to see a simplified depiction of how local returns, currency effects, and hedging feed into a base-currency-level performance figure:

    graph LR
	    A["Local Return <br/>(In Security’s Currency)"]
	    B["Currency Return <br/>(Change in FX Rate)"]
	    C["Hedging Impact <br/>(Overlay/Policy)"]
	    D["Consolidated Base <br/>Currency Return"]
	
	    A --> D
	    B --> D
	    C --> D

The nodes above illustrate that you need to measure each piece—local return, currency return, and hedging impact—separately. You then combine them to see how they influence the final reported performance in the base currency.

Avoiding Double-Counting

I had a friend who accidentally combined local currency returns with the currency gain/loss calculations in two different ways. The portfolio ended up looking like it had delivered absolutely spectacular performance—until we realized it was an overstatement from double-counting. That was a rather embarrassing conversation with a client. The best practice here is to systematically design your performance measurement system to isolate each effect only once.

Case Example

Suppose you manage a globally diversified equity portfolio denominated in GBP. Over the quarter, the portfolio invests in:

• US equities (40% of portfolio)
• Eurozone equities (40% of portfolio)
• Japanese equities (20% of portfolio)

Say, US equities (in USD) returned 5% in local terms, while USD appreciated 2% relative to GBP. Eurozone equities gained 1% in local terms, but the euro depreciated 2% relative to GBP. Japanese equities gained 3% in JPY terms, while JPY depreciated 1% against GBP.

If we compute the base-currency returns using the formula \((1 + \text{Local Return})(1 + \text{FX Return}) - 1\), we get:
• US equities in GBP ≈ \((1 + 0.05) \times (1 + 0.02) - 1 \approx 7.1%\)
• Eurozone equities in GBP ≈ \((1 + 0.01) \times (1 - 0.02) - 1 \approx -1%\)
• Japanese equities in GBP ≈ \((1 + 0.03) \times (1 - 0.01) - 1 \approx 1.97%\)

Now you’d weight these returns by the portfolio allocations (assuming no rebalancing during the period) to get the overall portfolio’s performance in GBP. If you had partially hedged your dollar exposure, you’d also factor in the cost of the hedge (or any realized gains).

Best Practices and Pitfalls

• Maintain consistency: Always use a single base currency for performance reporting, even if you hold multiple currencies.
• Keep a separate record of local returns vs. currency returns: Helps attribute performance properly.
• Watch out for transaction and hedging costs: If you do a lot of currency trades, those costs add up and should be accounted for in your performance.
• Avoid complicated layering: If you have partial hedges, forward contracts, or options, outline them clearly in your attribution process.
• Monitor or specify benchmarks: If your benchmark is unhedged, but you hedge 100%, your currency results might diverge from the benchmark’s significantly. Clarify that in performance reports.

Glossary

Base Currency: The currency in which portfolio results are typically reported. For instance, a UK manager might use GBP as the base currency, while a US manager would use USD.

Active Currency Management: Taking discretionary stances on currency movements to generate alpha. This method can add or subtract from returns, depending on the manager’s accuracy in forecasting exchange rates.

Currency Overlay: A separate strategy or manager that focuses solely on handling and possibly hedging the currency exposures in a portfolio. It’s like a specialized caretaker for your currency risk.

References

• CFA Program Curriculum, “Currency Management: An Introduction.”
• Solnik, Bruno and Dennis McLeavey, “International Investments.”
• CFA Institute Code and Standards on Performance Reporting.

Final Exam Tips

• During the Level III exam, you might see scenario-based questions asking how to attribute currency returns vs. local market returns. Be prepared to do the decompositions step by step.
• Pay attention to currency hedging calculations. The exam might test your understanding of how to measure returns from partially or fully hedged exposures.
• Review how benchmark currency exposures compare to the actual portfolio’s exposures. Scenario-based item sets often revolve around these differences.
• If you get a constructed response question about multi-currency attribution, show each step. Vague responses receive partial credit at best.
• Time management: Don’t let the math slow you down. Practice quick computations for (1 + R_local)(1 + R_FX) - 1 so you can handle them almost automatically.

Evaluate Your Mastery: Multi-Currency Performance Measurement