State Street launches dynamic FX hedging in Asia

US asset manager State Street Global Advisors (SSgA) last week launched its dynamic strategic hedging (DSH) programme for Asian markets to manage institutional investors' currency risk.

SSgA already offers the programme in 10 developed-market currencies and will now provide its investment strategy in the most liquid emerging currencies, in China, Hong Kong, Indonesia, India, the Philippines, Singapore, South Korea, Thailand and Taiwan.

Launched in 2006, SSgA's DSH programme has more than $10 billion in assets under management across 31 currencies in emerging and developed markets. "Our recent interaction with Asian institutions following the recent launch of DSH for Asian FX sounds promising," says Kelly Driscoll, Hong Kong-based head of SSgA for Asia ex-Japan.

Collin Crownover, London-based global head of currency management at SSgA, adds: "Given current market volatility, the effective management of currency risk attached to international investments has become a high priority for investors. Dynamic strategic hedging has been shown to reduce currency losses and deliver gains for clients using developed market currencies."

Although bond portfolios are usually FX-hedged, whereas equity portfolios often are not, investors are usually looking at currency-hedging techniques for both fixed-income and equity portfolios, says Driscoll. DSH applies to any kind of international exposures that could have equity or bond underlyings.

Equity investors often want local-currency exposure, as it can boost the performance of emerging-market equities. That may be especially true for dollar-based investors for the coming months and years, as Asian currencies are broadly expected to strengthen against the greenback.

Deutsche Bank says in a late-April report that it expects Asian FX to contribute a higher proportion of returns this year than last, as compared to Asian stocks. In 2009, foreign investors earned 64% in local equities, but just 3% in Asian FX, says the bank, but 2010 will see Asian currencies generate at least half of the total return for dollar-based investors.

Of course, the flipside is true for Asia-based investors with international exposures. "The expected appreciation of [Asian investors'] base currencies will lead to currency losses on their international exposures," Driscoll tells AsianInvestor. "Consequently we believe that this is an excellent time for investors to consider currency-hedging techniques."

"On top of elevated currency volatility, the under-valuation gap between Asian currencies and international currencies is progressively narrowing," she adds. "The more nimble you can be in managing the hedge ratio depending on this valuation gap, the more successful you can be in reducing your currency losses."

DSH can reduce currency losses because, unlike traditional 'static' hedging, it tailors and systematically adjusts hedge ratios for each currency pair in a portfolio according to their deviation from long-term fair-value, says SSgA.

Currency risk is an inevitable by-product of investing in international assets. Over five-and 10-year periods, losses from unmanaged currency risk can be much larger than investors realise, frequently turning gains from foreign-currency investments into losses, says Crownover.

Declining returns on investment in illiquid strategies such as private equity, real estate and infrastructure have heightened the impact of currency movements on the performance of these asset classes. That may explain why investors in illiquids -- typically not active in FX hedging -- are increasingly paying for currency hedges, according to some in the market.

Moreover, the theory that currency gains and losses would inevitably 'wash out' at zero over even longer horizons has been frequently disproved, says SSgA.

That makes DSH particularly relevant to institutional investors that are unlikely to tolerate extreme cumulative currency losses, argues Driscoll. "With returns on international assets expected to remain subdued, minimising investors' currency losses without entirely eliminating the chance to add excess returns is important."

Hedging emerging-market currencies, however, is more difficult than in more liquid currency pairs, such as dollar/euro or dollar/yen. How does SSgA deal with that?

The firm has been managing and trading 21 emerging-market currencies since 2004, says Driscoll. It often uses non-deliverable forwards (NDFs) -- offshore instruments used where onshore trading of a currency is restricted, such as in renminbi or Malaysian ringgit.  

SSgA clearly took the illiquidity issue into account when it developed its DSH model for Asian currencies. "For example, when we look at the valuation of the RMB, we look at the valuation that is embedded in the RMB NDF market," says Driscoll. "As you can imagine, most of the upcoming appreciation of the RMB is already priced in and thus our model for DSH in RMB doesn't imply extreme positions."

With $89 billion in assets under management, SSgA's global currency-management team has managed currencies since 1989. The currency management team comprises 31 investment professionals in Sydney, Tokyo, Hong Kong, London, Montreal and Boston.