Currency Overlay Mandates

A US pension fund that buys European stocks did not sign up to bet on the euro — it wanted exposure to European companies. But owning a euro-denominated stock means the fund's dollar-value return depends on both the stock's performance and the euro's move against the dollar, bundled together whether the fund likes it or not. A currency overlay is a separate, dedicated mandate — usually run by a specialist manager distinct from the stock or bond picker — whose sole job is managing that currency piece, typically using forwards, without touching the underlying securities at all.

Why it is run separately

Bundling currency decisions into the stock picker's job would ask one manager to be expert at two very different skills — picking companies and forecasting exchange rates — and would make it hard to tell, after the fact, how much of the fund's return came from stock selection versus a currency bet nobody explicitly signed off on. Separating the two lets the fund's trustees set an explicit currency policy — say, hedge 50% of developed-market currency exposure back to the dollar — and hire a specialist to execute exactly that, using rolling FX forward contracts sized to the (constantly moving) market value of the underlying foreign holdings, while judging its performance purely on how well it executed that currency policy.

Worked example

A pension fund holds $400 million of European equities and its policy calls for a 50% currency hedge ratio. The overlay manager sells euros forward (against dollars) in a notional amount of $200 million — half the portfolio's current value — via 3-month rolling forward contracts. If the euro then weakens 6% against the dollar over the quarter, the unhedged half of the portfolio loses roughly 6% x $200 million = $12 million of value purely from the currency move, while the hedged half's forward position gains a roughly offsetting amount, so the fund's total currency-driven loss is cut to about half of what a fully unhedged position would have suffered. Because the equity value itself moves with the market, the overlay manager rolls the forward's notional up or down each quarter to keep tracking roughly 50% of the current market value, not the original $400 million.

What this means in practice

Overlay mandates let large institutional investors separate "what do I want to own" from "how much currency risk do I want," and they are judged against a specific benchmark — typically the return of holding the policy hedge ratio passively — so that the overlay manager's skill (or lack of it) in timing and executing hedges shows up cleanly, isolated from the performance of the underlying stock or bond picks.