How Active Currency Overlay Can Materially Improve Upon Passive Currency Hedging

It is a common understanding that when investing in international assets, there are two sources of risk, first, the volatility that comes from the underlying asset itself (typically equities or bonds) and second, the volatility of the currency in which the international asset is denominated versus the base currency of the portfolio.

Institutional investors typically invest in international assets to access the risk premia available in overseas markets as this can provide attractive return opportunities.  However, historically, many investors have chosen to hedge the currency risk associated with these overseas investments by employing a passive currency hedge within the portfolio:  This commentary argues that by employing a passive currency hedge is sub-optimal and beset with potential problems and that an active approach to managing the currency risk is superior and can materially improve the risk/return characteristics of the overall portfolio.