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					                                                                                                                                                                    The General Framework for
                                                                                                                                                                    Global Investment Management
                                                                                                                                                                    and Performance Attribation
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                                                                                                                                                                    Solving the currency manqement problem in global investing.

                                                                                                                                                                    Brian D. Singer and Denis S. Karnosky




                                                                                                                                                                                                                                 he trend toward globalization of investment


                                                                                                                                                                                                                      T          portfolios has generated increased interest in
                                                                                                                                                                                                                                 the problem of currency management.
                                                                                                                                                                                                                                 While substantial effort has gone into ireas
                                                                                                                                                                                                                     such as hedged versus unhedged benchmarks and. the
                                                                                                                                                                                                                     development of currency overlay programs, less atten-
                                                                                                                                                                                                                     tion has been given to the larger issue of developing a
                                                                                                                                                                                                                     framework for analysis of global capital markets within
                                                                                                                                                                                                                     a unified, portfolio context.
                                                                                                                                                                                                                             The purpose of this article is to introduce a gen-
                                                                                                                                                                                                                     eral framework for global investment management and
                                                                                                                                                                                                                     performance attributi0n.l This framework partitions
                                                                                                                                                                                                                     the returns from global assets into distinct market and
                                                                                                                                                                                                                     currency components, allowing for unambiguous anal-
                                                                                                                                                                                                                     ysis and attribution of global returns.

                                                                                                                                                                                                                     DEFINING THE MARKET AND
                                                                                                                                                                                                                     CURRENCY VARIABLES

                                                                                                                                                                                                                            While the attention often is on currency issues, a
                                                                                                                                                                                                                     global investment framework should account for both
                                                                                                                                                                                                                     market and currency decisions simultaneously, so that
                                                                                                                                                                                                                     these strategies work in concert to achieve optimal joint
                                                                                                                                                                                                                     performance. We can show the nature of the interde-
                                                                                                                                                                                                                     pendence of market and currency returns using a portfo-
                                                                                                                                                                   BRIAN D. SINGER is partner and                    lo of just three assets denominated in three currencies.
                                                                                                                                                                                                                      i
                                                                                                                                                                   DENIS S KARNOSKY is m a g -
                                                                                                                                                                             .                                       This example is complex enough to demonstrate all the
                                                                                                                                                                   ing partner at Brinson Partners, Inc., a          generic strategic issues involved in global portfolios.
                                                                                                                                                                   global investment management firm                        Assume we are looking at the portfolio of a U.S.
                                                                                                                                                                   i Chicago (IL 60604).
                                                                                                                                                                    n                                                investor who holds assets denominated in dollars, ster-

                                                                                                                                                     84   THE GENERAL FRAMEWORK FOR GLOBAL INVESTMENT MANAGEMENT AND PERFORMANCEATTRIBUTION                         WINTER 1995
                                                                                                                                                     ling, and yen. The total dollar return of this portfolio               In this example, a dollar strategy would increase
                                                                                                                                                     with no currency hedgng would be2                              the total returns of the portfolio only if the dollar
                                                                                                                                                                                                                    return from U.S. cash equivalents is greater than the
                                                                                                                                                                                                                    dollar return from the foreign cash equivalents:

                                                                                                                                                     where

                                                                                                                                                     Rs = portfolio return in U.S. dollars;
                                                                                                                                                     wi    = weight of each country asset (Zwi = 1.0);
                                                                                                                                                                                                                                '(cy   +    E$,&
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                                                                                                                                                           -
                                                                                                                                                     ri    - local currency return from country(i) assets;             In fact, the returns associated with all currency
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                                                                                                                                                             and                                               strategies in any portfolio can be represented by the
                                                                                                                                                           - rate of change of the dollar exchange rate rel-   individual country cash returns, converted into the base
                                                                                                                                                     5.i
                                                                                                                                                             ative to currency(i).                                                          hs
                                                                                                                                                                                                               currency of the investor. T i general proposition can
                                                                                                                                                                                                               be demdnstrated by considering the hll set of alterna-
                                                                                                                                                             Returns &om investments in the U.K. and Japan tives for handling the yen exposure of this hypothetical
                                                                                                                                                     are the joint result of the respective local currency portfolio.
                                                                                                                                                     returns (ri) and the rates of change of the associated            The investor has three basic options:
                                                                                                                                                     exchange rates (E~,~).
                                                                                                                                                             In the simple case of fully hedging into the U.S. 1. A yen strategy that maintains the unhedged yen posi-
                                                                                                                                                     dollar, the exchange rate components of the U.K. and           tion that results from the market strategy.
                                                                                                                                                     Japanese positions are replaced by the respective for- 2. A dollar strategy that hedges yen into the dollar.
                                                                                                                                                     ward premiums or discounts (fs,i). The fully hedged 3. A sterling strategy that cross-hedges the yen into a
                                                                                                                                                     return, in U.S. dollars, is                                    third currency, which would be sterling in this case.

                                                                                                                                                                                                                           The dollar returns from applying each of these
                                                                                                                                                                                                                    currency strategies to the Japanese holdings within the
                                                                                                                                                           Equations (1) and (2) show that the decision on          portfolio are given in Equations (3) through (5).
                                                                                                                                                     hedging involves comparison of the known returns
                                                                                                                                                     from forward contracts and the expected changes in                %=Y
                                                                                                                                                                                                                         '       +   &$,y             wen Strategy)           (3)
                                                                                                                                                     exchange rates. It is advantageous to hedge into dollars
                                                                                                                                                     when the forward return is greater than the expected              HR, = Y + f$,Y
                                                                                                                                                                                                                             r                        (Dollar Strategy)       (4)
                                                                                                                                                     percentage change in the exchange rate:
                                                                                                                                                                                                                       CRgy= ry + (fsy + ~           3
                                                                                                                                                                                                                                                   $ (Sterling Strategy)      (5)

                                                                                                                                                                                                                          Substituting the cash return difterentials (cr - GJ
                                                                                                                                                                                                                    and (cE- 4 for the forward returns in Equations (4)
                                                                                                                                                                                                                    and (5) and rearranging terms gives:
                                                                                                                                                             It is informative, however, to look deeper into
                                                                                                                                                     the relationship between spot and forward exchange
                                                                                                                                                     rates. Arbitrage activity assures that forward returns are
                                                                                                                                                     effectively equal to the difference between term inter-
                                                                                                                                                     est rates (f . = c. - ci). Thus, the currency decision actu-
                                                                                                                                                                J.'    1
                                                                                                                                                     ally involves comparison of interest rate differentials to
                                                                                                                                                     expected changes in exchange rates. In this example,
                                                                                                                                                     hedging into dollars is advantageous when:                            The differences among th9 dollar returns from
                                                                                                                                                                                                                    the three currency strategies in Equations (6)
                                                                                                                                                                                                                    through (8) are due entirely to differences in expect-
                                                                                                                                                                                                                    ed cash returns in dollar terms. These cash returns
                                                                                                                                                                                                                    are the full measure of the currency returns associat-

                                                                                                                                                     WINTER 1995                                                                            THE JOURNAL OF PORTFOLIO MANAGEMENT   85
                                                                                                                                                      ed with each currency strategy. Repeating this exer- rency decision involves the fixmer, global cash man-
                                                                                                                                                      cise for the U.S. and U.K assets in this example agement, and the asset decision involves the latter,
                                                                                                                                                      would show that these three cash terms define the risk premium management.
                                                                                                                                                      respective currency returns.
                                                                                                                                                             Since interest rate differentials determine for- THE FRAMEWORK FOR
                                                                                                                                                     ward premiums and discounts, local cash returns are an PERFORMANCE ATTRIBUTION
                                                                                                                                                     inseparable component of cuuency returns. The array
                                                                                                                                                     of cash returns in terms of the base currency (ci + E ~ , ~ )       Brinson et al. [1986, 19911 present a framework
                                                                                                                                                     are unambiguous measures of the returns that are asso- for separating portfolio returns into active asset alloca-
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                                                                                                                                                     ciated with the various currency strategies. Therefore, tion and security selection components. This concep-
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                                                                                                                                                     only the portion of the local currency return in excess tual framework is directly applicable to global portfo-
                                                                                                                                                     of the local cash return, the risk premium (ri - ci), is lios, requiring only a separation of asset allocation :Into
                                                                                                                                                     available as a pure market return.                          market and currency components. The attribution to
                                                                                                                                                             As shown in Equations (6) through (8), only the     security selection activity is unaffected by the introchc-
                                                                                                                                                     portion of the local currency return in excess of the tion of multiple currencies and can follow the Brinson
                                                                                                                                                     local cash return (ry - c is the measure of the Japanese framework exactly.
                                                                                                                                                                             $
                                                                                                                                                     market return. It is this local risk premium,, rather than          The portion of the portfolio’s added value that
                                                                                                                                                     the local currency return (I+), that is the unambiguous can be attributed to each market allocation decision is
                                                                                                                                                     measure of market return, Similar return premiums computed as:
                                                                                                                                                     define the market returns for the U.K. and U.S. assets
                                                                                                                                                     in the portfolio.
                                                                                                                                                             The exposure to changes in exchange rates is the
                                                                                                                                                     net effect of two strategic decisions: 1) the market deci-
                                                                                                                                                     sion to invest in the assets of the various ‘countries,as
                                                                                                                                                                                                                         Market
                                                                                                                                                                                                                          Allocation =
                                                                                                                                                                                                                         Returns
                                                                                                                                                                                                                                               Active       Passive
                                                                                                                                                                                                                                              Market - Market x
                                                                                                                                                                                                                                              Weight        Weight      I
                                                                                                                                                     reflected in the weights, and 2) decisions to buy and sell
                                                                                                                                                     currency exposures forward, as reff ected in the hedge
                                                                                                                                                     weights. Yet it is the portfolio’s total exposure to each
                                                                                                                                                     currency (Si) rather than specific market and currency
                                                                                                                                                                                                                           Passive Local            Index Local
                                                                                                                                                                                                                           Currency Market - Currency Market
                                                                                                                                                                                                                           Risk Premium             Risk Premium ,           I
                                                                                                                                                     hedge sources of that exposure that is relevant.            In this equation the term “index” refers to the pordo-
                                                                                                                                                             Thus, the base currency return from a global lio’s benchmark.
                                                                                                                                                     portfolio can be written in terms of separate market and            The value added by each specific currency d o -
                                                                                                                                                     currency components as:                                     cation decision is computed as:

                                                                                                                                                              Rn= Cwi(ri- ci) + Z:6i(ci+ E”,~)
                                                                                                                                                     where Cwi =      si= 1.0.
                                                                                                                                                            Evaluation of risk premiums and cash in glob-
                                                                                                                                                                                                                  (9)         Currency

                                                                                                                                                                                                                              Returns
                                                                                                                                                                                                                                                 Active
                                                                                                                                                                                                                                                 Currency
                                                                                                                                                                                                                                                 Weight
                                                                                                                                                                                                                                                            -’
                                                                                                                                                                                                                                                                 Passive
                                                                                                                                                                                                                                                                 Currency
                                                                                                                                                                                                                                                                 Weight  I   x


                                                                                                                                                     al capital markets is consistent with the Capital Asset
                                                                                                                                                     Pricing Model, where risky assets are disthguished by
                                                                                                                                                     their returns relative to the riskless (cash) asset. With
                                                                                                                                                     less than full global capital market integration, there
                                                                                                                                                     are multiple cash equivalents that differ j.n their cur-
                                                                                                                                                                                                                                Passive Cash
                                                                                                                                                                                                                                Returns in
                                                                                                                                                                                                                                U.S. Dollars
                                                                                                                                                                                                                                               Index Cash
                                                                                                                                                                                                                                             - Return in
                                                                                                                                                                                                                                               U.S. Dollars       I
                                                                                                                                                                                                                                Additional portions of the portfolio’s added
                                                                                                                                                     rency of denomination and reflect differential infla-              value can be attributed to security selection and to
                                                                                                                                                     tion rates. Since the relevant cash instrument for the             hedge selection. The contribution attributable to secu-
                                                                                                                                                     U.S. investor is U.S. cash, the global investment eval-            rity selection is:
                                                                                                                                                     uation process can be thought of as flowing from
                                                                                                                                                     domestic riskless cash to foreign cash, including the                      Market     Passive
                                                                                                                                                     unavoidable consideration of exchange rates, and on                        Security = Market x
                                                                                                                                                     to the foreign assets relative to foreign cash. The cur-                   Selection  Weight

                                                                                                                                                     86   THE GENERAL lXAivlEWO€X FOR GLOBAL INVESTMENT MANAGEMENT AND PERFORMANCE AlTRlBUTION                         WINTER 1995
                                                                                                                                                     EXHIBIT 1
                                                                                                                                                     A Framework for Global Portfolio Return Accountability

                                                                                                                                                                                Market Attribution:                                           Currency Attribution:
                                                                                                                                                                                 Security Selection                                             Hedge Selection
                                                                                                                                                                           Actual                 Passive                               Actual                Passive



                                                                                                                                                       M                   Actual                Policy and           C     A           Actual                 Policy and
                                                                                                                                                              A
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                                                                                                                                                       a
                                                                                                                                                              C
                                                                                                                                                                       Local Currency         Active Allocation       U
                                                                                                                                                                                                                             C
                                                                                                                                                                                                                                    Base Currency           Active Allocation
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                                                                                                                                                       r
                                                                                                                                                              t
                                                                                                                                                                       Risk Premium            Local Currency         r
                                                                                                                                                                                                                             t       Cash Return             Base Currency
                                                                                                                                                       k      U
                                                                                                                                                                                               Risk Premium           r
                                                                                                                                                                                                                             U
                                                                                                                                                                                                                                                              Cash Return
                                                                                                                                                       e                                                              e
                                                                                                                                                              a                                                              a
                                                                                                                                                        t              Active Weights            Active Weights       n             Active Weights           Active Weights
                                                                                                                                                              1                                                              1
                                                                                                                                                                       Active Returns            Passive Returns      C             Active Returns           Passive Returns
                                                                                                                                                       S                                                              Y
                                                                                                                                                       e                   M(II1)                     M(I)                               C(II1)
                                                                                                                                                        1                                                             S
                                                                                                                                                        e     P          Policy and                  Policy           e      P       Policy and                  Policy
                                                                                                                                                       C      a       Security Selection         Local Currency       1      a     Hedge Selection           Base Currency
                                                                                                                                                        t     S        Local Currency            Risk Premium         e      S     Base Currency              Cash Return
                                                                                                                                                        i     S        Risk Premium                                   C      S      Cash Return
                                                                                                                                                       0      i                                                       t      i
                                                                                                                                                       n      V        Passive Weights           Passive Weights      i      V      Passive Weights          Passive Weights
                                                                                                                                                              e        Active Returns            Passive Returns      0      e      Active Returns           Passive Returns
                                                                                                                                                                                                                      n

                                                                                                                                                     Active Market Returns Due to:                                 Active Currency Returns Due to:
                                                                                                                                                     Market Selection               M(I1) - M(I)                   Currency Selection               C(I1) - C(I)
                                                                                                                                                     Security Selection            M(II1) - M(I)                   Hedge Selection                  C(II1) - C(I)
                                                                                                                                                     Other                  M(1V) - M(II1) - M(II) + M(1)          Other                    C(Iv) - C(II1) - C(I1) + C(I)
                                                                                                                                                     Total                         M(1V) - M(1)                    Total                             C(Iv) - C(I)


                                                                                                                                                                  Active Local
                                                                                                                                                                  Currency
                                                                                                                                                                  Market Return
                                                                                                                                                                                -
                                                                                                                                                                                           Passive Local
                                                                                                                                                                                           Currency
                                                                                                                                                                                           Market Return


                                                                                                                                                             The portion attributable to hedge selection is:3
                                                                                                                                                                                                             I     the interaction of the active allocation and selection
                                                                                                                                                                                                                   decisions.
                                                                                                                                                                                                                          Exhibit 2 provides passive weight and return data
                                                                                                                                                                                                                   for performance evaluation from the perspective of a
                                                                                                                                                                                                                   U.S. investor. Among these four markets, the U.K.
                                                                                                                                                                                                                   offers the best local currency return, but the pound
                                                                                                                                                              Currency    Passive                                  sterling shows the largest depreciation against the dol-
                                                                                                                                                              Hedge     = Currency           X                     lar. The deutschemark shows the largest appreciation
                                                                                                                                                              Selection   Weight                                   against the dollar, but the German asset market has the
                                                                                                                                                                                                                   lowest local currency return. The best unhedged dollar
                                                                                                                                                                  Active Local
                                                                                                                                                                  Currency
                                                                                                                                                                  Cash Return
                                                                                                                                                                                 -
                                                                                                                                                                                     Passive Local
                                                                                                                                                                                     Currency
                                                                                                                                                                                     Cash Return      1
                                                                                                                                                            The formulas represent differences in the quad-
                                                                                                                                                                                                                   return is provided by Japanese securities.
                                                                                                                                                                                                                           There are sixteen potential combinations of
                                                                                                                                                                                                                   market and currency exposures that a portfolio manag-
                                                                                                                                                                                                                   er could create from these four markets and four cur-
                                                                                                                                                                                                                   rencies. Exhibit 3 indicates the total dollar return pro-
                                                                                                                                                     rants defined in Exhibit 1. The active contribution of        vided by each of these combinations. Unhedged dollar
                                                                                                                                                     both market and currency management constitutes               returns are o n the diagonal, while hedged dollar returns
                                                                                                                                                     active market and currency allocation, active security        appear in the last column. All other currency strategies
                                                                                                                                                     and hedge selection, and cross-products that measure          involve cross-hedging. The hedged and cross-hedged

                                                                                                                                                     WINTER 1995                                                                         THE JOURNALOF PORTFOLIO WNAGEMENT     87
                                                                                                                                                     EXHIBIT 2
                                                                                                                                                     Global Security Returns (%)*
                                                                                                                                                                                                                                                      ~   _ _ _ _ _ ~ ~ _______    ~




                                                                                                                                                                                                  Local                                                          Local
                                                                                                                                                                                                 Currency            Exchange              Market               Currency
                                                                                                                                                                            Index                 Market               Rate              Returns in              Cash
                                                                                                                                                     Market                Weights               Returns             Returns             U S Dollars
                                                                                                                                                                                                                                          ..                    Returns
                                                                                                                                                                                                                                                          --                       -
                                                                                                                                                      Germany                25.0                  7.00                  1.00                  8.00                 5.00
                                                                                                                                                     U.K.                    25.0                 10.50                -3.00                   7.50                11.25
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                                                                                                                                                     Japan                   25.0                  9.50                -1 .oo                  8.50                 9.00
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                                                                                                                                                     US..                    25.0                  8.40                  0.00                  8.40                 7.50
                                                                                                                                                     Index                  100.0                  8.85                -0.75                   8.10                 8.19

                                                                                                                                                     *Continuously compounded rates of return.

                                                                                                                                                     returns reflect the forward exchange rates that are              return in this example, the performance attribution sys-
                                                                                                                                                     implied by the cash returns in Exhibit 2.                        tem should show a positive ex post contribution from
                                                                                                                                                             Notice that in each column in Exhibit 3                  an overweight of the German market. Notice, howev-
                                                                                                                                                     German securities provide the highest dollar return.             er, that German securities have both local currency md
                                                                                                                                                     That is, German assets offer the best base currency              unhedged returns that are inferior to the associated
                                                                                                                                                     return, irrespective of the currency strategy. Also,             index return. The index of local currency returns for
                                                                                                                                                     looking across each row, a sterling currency strategy            these four markets is 8.85% versus 7.00%for Germany,
                                                                                                                                                     gives the highest dollar return. Whatever the market             whde the index of unhedged dollar returns is 8.10%
                                                                                                                                                     strategy, a sterling currency strategy gives the best base       versus 8.00% for Germany.
                                                                                                                                                     currency return.                                                         If either local currency or unhedged returns
                                                                                                                                                            In terms of maximizing returns, the German                were used as the basis for attributing returns, a porlfo-
                                                                                                                                                     market and sterling currency exposures are unambigu-             lio that overweights German securities would show a
                                                                                                                                                     ously the best. The portfolio that offers the highest dol-       negative market selection effect for the c'rerman stcite-
                                                                                                                                                     lar return would be invested completely in German                gy. In other words, using either of these criteria within
                                                                                                                                                     securities cross-hedged into sterling. The resulting             a global attribution system would give the investment
                                                                                                                                                     10.25% dollar return reflects the 7.0% deutschemark              manager an incentive to avoid the German market, to
                                                                                                                                                     return from German securities, the 6.25%; (11.25% -              the detriment of total portfolio performance.
                                                                                                                                                     5.00%) sterling return from selling deutschemarks for-                  Using the data presented in Exhibit 2, we can
                                                                                                                                                     ward into British pounds, and the 3.0% loss from                 specify the dollar returns from each market in terms of
                                                                                                                                                     depreciation of sterling against the dollar.                     components that give an unambiguously correct rank-
                                                                                                                                                            Since a market strategy of overweighting                  ing of relative market and currency returns that are
                                                                                                                                                     German securities must enhance the dollar portfolio              available to the investor, i.e., the local risk premiums and
                                                                                                                                                                                                                      cash returns in dollars for each of the four countries. In
                                                                                                                                                                                                                      Exhibit 4,Germany gives the largest risk premium (Le.,
                                                                                                                                                     EXHIBIT 3
                                                                                                                                                     Dollar Returns from All Combinations of Market and
                                                                                                                                                                                                                      the greatest return in excess of the local cash retutn),
                                                                                                                                                     Currency Strategies (%)*                                         while U.K. cash has the highest dollar return.
                                                                                                                                                                                                                             In this example, only market strategies that over-
                                                                                                                                                     Market                   Currency Strategy-                      weight Germany and/or the U.S. can produce returns
                                                                                                                                                     Strategy      Deutschemark Sterling      Yen           Dollar    that are superior to the benchmark, irrespective of the
                                                                                                                                                                                                                      associated currency strategies. These are the only mar-
                                                                                                                                                     Germany            8.00           10.25      10.00      9.50     kets that offer risk premiums in excess of the 0.66%
                                                                                                                                                     U.K.               5.25            7.50       7.25      6.75
                                                                                                                                                     Japan              6.50            8.75       8.50      8.00     index premium. Among the currency alternatives, only
                                                                                                                                                     us.                6.90            9.15       8.90      8.40     strategies that overweight sterling, yen, and/or the 1J.S.
                                                                                                                                                                                                                      dollar can enhance performance, irrespective of the
                                                                                                                                                     *Continuously compounded rates of return.                        underlying market stratew. These are the only cash

                                                                                                                                                     88   THE GENERAL FRAMEWORK FOR GLOBAL INVESTMENT MANAGEMENT AND PERFORMANCE ATTRIBUTION                               WINTEF: 1995
                                                                                                                                                     markets that offer dollar returns above the 7.44% cash EXHIBIT 4
                                                                                                                                                     return of the index.                                       Global Market and Currency Variables (%)*
                                                                                                                                                             Consider a U.S. dollar-based portfolio with an
                                                                                                                                                     unhedged benchmark invested in these four markets.                           Local Currency          Cash R t r s in
                                                                                                                                                                                                                                                                eun
                                                                                                                                                                                                                Market          Market h s k Premium       U.S. Dollars
                                                                                                                                                     Exhibit 5 summarizes the market and currency posi-
                                                                                                                                                     tions of this portfolio. Exhibit 6 summarizes the passive Germany                    2.00                  6.00
                                                                                                                                                     returns provided by the portfolio benchmark and the U.K.                           -0.75                   8.25
                                                                                                                                                     actual returns earned by the portfolio. The table indi- Japan                        0.50                  8.00
                                                                                                                                                     cates that security selections in the U.K., Japan, and the U.S.                      0.90                  7.50
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                                                                                                                                                     U.S. add value and afford local currency market returns Index (Exhibit 2)            0.66                  7.44
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                                                                                                                                                     in excess ,of the passive ones.                            'Continuously compounded rates of return.
                                                                                                                                                             To simplify the discussion, we assume that active
                                                                                                                                                     hedge management, such as the use of long-term for-
                                                                                                                                                     wards or options, does not occur. Thus, the passive and las provided in Exhibit 8.
                                                                                                                                                     actual cash returns in U.S. dollars for the individual             The attribution provides results that are consis-
                                                                                                                                                     markets are equal.                                         tent with the efficacy of the market and currency
                                                                                                                                                             The market strategy is to overweight German decisions. The market allocation contribution is indi-
                                                                                                                                                     securities and underweight each of the other markets cated as positive (69 basis points), accurately reflecting
                                                                                                                                                     relative to the benchmark. The currency strategy is to the value added from both the overweight of
                                                                                                                                                     underweight deutschemarks, with deutschemarks sold Germany and the underweight of the U.K. Since,
                                                                                                                                                     forward into sterling and yen. While the portfolio is from Exhibit 3, the German market would have con-
                                                                                                                                                     overweighted in the German market, and under- tributed the most to the total return of the portfolio
                                                                                                                                                     weighted in deutschemarks, the opposite is true for and the U.K. the least, the market selection results of
                                                                                                                                                     sterling. Even though the Japanese market is strategical- the attribution are appropriate.
                                                                                                                                                     ly underweighted, the hedge into yen results in a neu-             The same observations can be made about the
                                                                                                                                                     tral allocation relative to the benchmark allocation. On deutschemark underweight and the sterling overweight.
                                                                                                                                                     balance, the portfolio is overweight sterling and under- Thus, the currency attribution is also consistent, show-
                                                                                                                                                     weight deutschemarks and dollars, and holds a neutral ing a 45-basis point addition to the portfolio's value.
                                                                                                                                                     yen exposure.                                              Security selection adds 28 basis point^.^ The absence of
                                                                                                                                                             This portfolio strategy produces a total dollar a residual indicates that all contributors to the differ-
                                                                                                                                                     return of 9.52%, 142 basis points above the bench- ence between the portfolio return of 9.52% and the
                                                                                                                                                     mark. This performance is the joint effect of market benchmark return of 8.10% are accounted fot5
                                                                                                                                                     and currency strategies and security selection within              Multiperiod attributions require an accounting
                                                                                                                                                     each market. Exhibit 7 provides the performance for changes in active weights and returns over time.
                                                                                                                                                     attribution for this portfolio according to the formu- While it may be convenient to add monthly attribution

                                                                                                                                                     EXHIBIT 5
                                                                                                                                                     Global Portfolio Strategy Summary (%)
                                                                                                                                                     ~~                                             ~~




                                                                                                                                                                                                                                  Currency Strategy
                                                                                                                                                                                     Market Strategy       Active
                                                                                                                                                                                 Active                    Market           Currency           Currency
                                                                                                                                                                    Index        Weight                    Weight           Hedging             Weight
                                                                                                                                                     Country        Weight         (w,)      Over/Under      (w,)     +        (h,)      =     (w,) + (h,)    Over/Under

                                                                                                                                                     Germany          25.0         60.0          35.0        60.0            -50.0                 10.0           -15.0
                                                                                                                                                     U.K.             25.0         10.0        -15.0         10.0              45.0                55.0             30.0
                                                                                                                                                     Japan            25.0         10.0        -15.0         10.0              15.0                25.0              0.0
                                                                                                                                                     U.S.             25.0         20.0         -5.0         20.0            -10.0                 10.0           -15.0

                                                                                                                                                     Total           100.0        100.0          0.0        100.0     +         0.0      =        100.0              0.0

                                                                                                                                                     WINTER 1 9 5                                                                      THE JOURNAL OF PORTFOLIO MANAGEMENT 89
                                                                                                                                                      EXHIBIT 6
                                                                                                                                                      Global Portfolio Return Summary*

                                                                                                                                                                                               Passive R.eturns                                         Actual Returns               -
                                                                                                                                                                                                                    Local         Cash                      Local         Cash
                                                                                                                                                                      Local         Local        Exchange          Market        Return      Local         Market        Return
                                                                                                                                                                     Market         Cash           Rate:            Risk         in US.     Market          Risk         in U.S.
                                                                                                                                                      Country        Returns       Returns        Return          Premium        Dollars    Return        Premium        Dollars

                                                                                                                                                                        A             B              C            (A-B)          (B + C)       D           (D -B)        (B + C)
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                                                                                                                                                     Germany           7.00          5.00            1.oo          2.00           6.00        6.80           1.80          6.00
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                                                                                                                                                     U.K.             10.50         11.25          -3.00          -0.75           8.25       12.25           1.oo          8.25
                                                                                                                                                     Japan             9.50          9.00          -1.00           0.50           8.00       10.50           1.50          8.00
                                                                                                                                                     U.S.              8.40          7.50            0.00          0.90           7.50        9.00           1.50          7.50

                                                                                                                                                     Total             8.85             8.19       -0.7.5          0.66           7.44         8.16          1.63         7.89

                                                                                                                                                     *Continuously compounded rates of return.


                                                                                                                                                     results or to use longer-term average weights and                    mance attribution, providing distinct: measures of mar-
                                                                                                                                                     returns, the results can be misleading at be:st and often            ket and currency investment performance. Although
                                                                                                                                                     wrong. Multiperiod attributions are best accomplished                the framework is designed to account for curreincy
                                                                                                                                                     by creating weighted return indexes to compute each                  exposures within non-U.S. and glok~al    portfolios, per-
                                                                                                                                                     attribution component.                                               haps the most interesting results are with regard to the
                                                                                                                                                            For example, active market selection would be                 market allocation decision. Correct attribution of the
                                                                                                                                                     computed by building several weighted indexes and dif-               performance contribution of currency allocation deci-
                                                                                                                                                     ferencing on full-period weighted returns. The com-                  sions places crucial but identifiable constraints on the
                                                                                                                                                     putations are similar for each attribution component.                attribution of market decisions.
                                                                                                                                                                                                                                 The fiamework offers several advantages aver
                                                                                                                                                     CONCLUSION                                                           attribution systems conventionally used. First, while
                                                                                                                                                                                                                          market allocations lead to currency exposures, th.ese
                                                                                                                                                            This article has developed a framewomrk for glob-             exposures need not be taken for granted. The frarne-
                                                                                                                                                     al and international portfolio management and perfor-                work provides a clean, unambiguous distinction

                                                                                                                                                     EXHIBIT 7
                                                                                                                                                     Value-Added Performance Attribution (%)

                                                                                                                                                     Country              Market Selection                        Currency Selection            Security Selection           Total
                                                                                                                                                                                                                                                                                     -
                                                                                                                                                     Germany                     0.47                                     0.22                           -0.12                0.57
                                                                                                                                                                      (0.60 - 0.25)(2.00 - 0.66)            (0.10 - 0.25)(6.00 - 7.44)             0.60(6.80 - 7.00)

                                                                                                                                                     U.K.                       0.21                                   0.24                            0.18                   0.63
                                                                                                                                                                     (0.10 - 0.25)(-0.75 - 0.66)            (0.55 - 0.25)(8.25 - 7.44)          O.lO(12.25 - 10.50)

                                                                                                                                                     Japan                       0.02                                  0.00                           0.10                    0.12
                                                                                                                                                                      (0.10 - 0.25)(0.50 - 0.66)            (0.25 - 0.25)(8.00 - 7.44)          O.lO(10.50 - 9.50)

                                                                                                                                                     U.S.                       -0.01                                 -0.01                              0.12                 0.10
                                                                                                                                                                      (0.20 - 0.25)(0.90 - 0.66)            (0.10 - 0.25)(7.50 - 7.44)             0.20(9.00 - 8.40)
                                                                                                                                                     Unexplained                  -                                       -                              -                    0.00

                                                                                                                                                     Total                       0.69                                     0.45                           0.28                 1.42

                                                                                                                                                     90   THE GENERAL FRAMEWORK FOR GLOBAL lNVESTMENT MANAGEMENT AND PERFORMANCE ATTRIBUTION                                WINTER. 1995
                                                                                                                                                     EXHIBIT 8
                                                                                                                                                     Summary of Global Performance Attribution Calculations

                                                                                                                                                     Market Attribution:
                                                                                                                                                     Return Due to                               Calculated by                                                                Market Quadrant Differences

                                                                                                                                                     Active Market Selection                     C{(wi         - Wi)[(q     - Ti)    - RP]}                                   Quadrant M(I1) - Quadrant M(I)
                                                                                                                                                                                                  i
                                                                                                                                                     ~        ~~




                                                                                                                                                     Security Selection                          cw( - q) -
                                                                                                                                                                                                  [ jq                      Fi(?- 4 ) ] = c E (- F)]
                                                                                                                                                                                                                                           [ iq                               Quadrant M(II1) -
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                                                                                                                                                                                                  i                                              1                            Quadrant M(I)
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                                                                                                                                                                                                 C{Cwi - Ei)[(q -                4) -   (P - ?)I)
                                                                                                                                                                                                                                                                              Quadrant M(1V)    -
                                                                                                                                                                                                                                                                              [Quadrant M(I1) +
                                                                                                                                                                                                  i
                                                                                                                                                     Market                                                                                                                   Quadrant M(II1)J +
                                                                                                                                                     Cross-Product                               = Cr(wi - Wi)(q -                  ~ I I                                     Quadrant M(1)
                                                                                                                                                                                                       I



                                                                                                                                                     Market Total                                                                                                             Quadrant M(1V)    -
                                                                                                                                                                                                                                                                              Quadrant M(I)

                                                                                                                                                     Currency Attribution:
                                                                                                                                                     Return Due to                               Calculated by                                                                Currency Quadrant Differences
                                                                                                                                                              ~~               ~       ~~   ~~             ~




                                                                                                                                                     Active Currency Selection                   c{[wi + hi) -
                                                                                                                                                                                                  i
                                                                                                                                                                                                                            (Ei   + hi)][& +         Zi) - C]}                Quadrant C(I1) - Quadrant C(1)


                                                                                                                                                                                                                +   6)(Ci   +   Ei)] - [(Wi      + T;,)(., + E,)])
                                                                                                                                                                                                  i

                                                                                                                                                     Hedge Selection                              =    C[(Wi + Q(Ci             - q)]                                         Quadrant C(II1)   - Quadrant C(1)
                                                                                                                                                                                                       1




                                                                                                                                                                                                  C{[(wj        +   9)-     ( i
                                                                                                                                                                                                                             a      + ii>It(ci +     ai)   - (5   +   zi)I)   Quadrant C(IV)
                                                                                                                                                                                                                                                                              [Quadrant c(II) +
                                                                                                                                                                                                                                                                                                -
                                                                                                                                                                                                                                                                              Quadrant C(II1)J +
                                                                                                                                                                                                   1


                                                                                                                                                     Currency Cross-Product                       =    C{[(wi + 4) - (E~ &)](ci - q)}
                                                                                                                                                                                                                       +                                                      Quadrant C(1)




                                                                                                                                                         Note: Lower-case letters indicate portfolio weights and returns; letters with a bar over them indicate passive benchmark weights and returns.

                                                                                                                                                     wi            =   weight of country i assets,
                                                                                                                                                                   =   return &om the assets of country i, in local-currency t e r n ,
                                                                                                                                                     ri
                                                                                                                                                     ci            =   return Erom country i Eurodeposits, in local-currency terms,
                                                                                                                                                     RP            =   aggregate passive benchmark local-currency return premium,
                                                                                                                                                     C             =   aggregate passive benchmark Eurodeposit return, in base-currency terms,
                                                                                                                                                                   =
                                                                                                                                                     hi                portion of portfolio hedged inco (positive) or out of (negative) currency i,
                                                                                                                                                     E,
                                                                                                                                                                   =   rate of change in the base currency: currency i exchange rate.


                                                                                                                                                     between the effects of market decisions a n d currency                               .   position, whether unhedged, fully hedged, or partially
                                                                                                                                                     decisions, reflecting the variables that managers c a n                                  hedged. Finally, a n d most important, it provides the
                                                                                                                                                     actually manage.                                                                         correct investment incentives, assuring that market a n d
                                                                                                                                                            Second, it applies to any benchmark currency                                      currency strategies can be set independently but w o r k

                                                                                                                                                     WINTER 1995                                                                                                         THEJOURNALOF PORTFOLIOMANAGEMENT 91
                                                                                                                                                      in concert to maximize portfolio performance.                                tion and the market cross-product. The resulting computation involves
                                                                                                                                                                                                                                   the actual market weight rather than the passive weight.
                                                                                                                                                             The proposed framework is a ftindamental
                                                                                                                                                                                                                                              5Allen [1991] recognizes the important impact that forward
                                                                                                                                                      change from current methods of global arid interna-                          contracts have on performance attribution. m i l e the impact of both
                                                                                                                                                      tional performance attribution. We believe, however,                         passive and active hedge decisions is accounted For, this occurs only at
                                                                                                                                                      that such a change is required in order to p:inpoint the                     the portfolio level because of the perceived complexity of forward cur-
                                                                                                                                                                                                                                   rency transaction. Also, holding the market manager accountable to an
                                                                                                                                                      actual contribution of market and currency strategies.                       unhedged benchmark, with a subordinate attribution of market 2nd
                                                                                                                                                     The practice of separating market allocation decisions                        currency exposures, is incorrect. An unhedged niarket selection critt:ri-
                                                                                                                                                     and currency overlay programs in particular necessitates                      on can lead to suboptimal market decisions and suboptimal portfcilio
                                                                                                                                                                                                                                   returns.
                                                                                                                                                     such a change.
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                                                                                                                                                             Evaluating performance in the proposed manner
                                                                                                                                                                                                                                   REFERENCES
                                                                                                                                                     - the market managedstrategy is measured against a
                                                                                                                                                     risk premium benchmark, and the currency manag-                                Allen, G.C. “Performance Attribution for Global Equity Portfolios.”
                                                                                                                                                     edstrategy is measured against a global cash benchmark                        Journal ofPorlfolio Management, Fall 1991, pp. 59-65.
                                                                                                                                                     - accurately accounts for the value-added by each
                                                                                                                                                                                                                                   Black, F., and R. Litterman. “Global Portfolio C)ptimization.” Finatuial
                                                                                                                                                     strategy. Interestingly, currently popular currency over-
                                                                                                                                                                                                                                   AnalystsJournal, September/October 1992, pp. 28-43.
                                                                                                                                                     lay programs are portrayed as a synthetic global cash
                                                                                                                                                     management strategy.                                                          Brinson, G.P., R. Hood, and G.L.Beebower. “Determinants of
                                                                                                                                                                                                                                   Portfolio Performance.” Financial Analysts Jounral, Jdy/August 1S86,
                                                                                                                                                                                                                                   pp. 39-44.
                                                                                                                                                     ENDNOTES
                                                                                                                                                                                                                                   Brinson, G.P., B.D. Singer, and G.L. Beebower. “Determinano, of
                                                                                                                                                                ‘This article is an abridged introduction to a monograph by        Portfolio Performance 11: An Update.” Fimruial Analysts Journal,
                                                                                                                                                     Kamosky and Singer [1994]. Other works examining the nature of the            May/June 1991, pp. 40-48.
                                                                                                                                                     relationships among assets and exchange rates in global portfolios include
                                                                                                                                                     Eun and Resnick [1988]; Lee [1987]; and Black and Litterman [1992].           Eun, C.S., and B.G. Resnick. “Exchange Rate Uncertainty, Fommd
                                                                                                                                                                 2Simplifjnngassumptions are that I) all returns, are in contin-   Contracts and International Portfolio Selection.” Journal of Fiwrue,
                                                                                                                                                     uously compounded terms, allowing simple addition and subtraction of          March 1988, pp. 197-215.
                                                                                                                                                     compound return terms, and 2) the investment objective is the maxi-
                                                                                                                                                     mization of returns, allowing risk considerations to be ipored.               Kamosky, Denis S., and Brian D. Singer. “Global Asset Management
                                                                                                                                                                 3An example of hedge selection is the return that is achieved     and Performance Attribution.” Charlottesville, VA: The Resexch
                                                                                                                                                     by entering forward transactions for a term that is di6;:rent &om the         Foundation of the Institute of Chartered Financ:ial Analysts, 1994.
                                                                                                                                                     normal forward term. Conceptually, this is no different &om account-
                                                                                                                                                     ing separately for security selection within the market attribution.          Lee, A.F. “International Asset and Currency Allocation.” Joumrd       of
                                                                                                                                                                 4We use a common convention of combining:security selec-          Portfolio Management, Fall 1987, pp. 68-73.




                                                                                                                                                     92   THE GENERAL FRAMEWORK FOR GLOBAL INVESTMENT MANAGEMENT AND PERFORMANCE ATIlllBUTlON                                                  WINTER. 1995

				
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