Rising Interest in Currency Funds

Investor interest in currencies is increasing.

The currency market dwarfs all other markets, trading over $4 trillion per day. The US Dollar dominates that trading, and the big four are the Dollar, the Euro, the Yen and the Pound. The Australian Dollar, the Canadian Dollar and the Swiss Franc make up the second rank by volume.

Some of the reasons for increased retail investors’ interest in currencies are:

1. retail spot currency trading platforms becoming more available,
2. the US Dollar faces major challenges as a result of monetary policy actions since the 2008 crash,
3. growing talk, and some action, among sovereign funds concerning diversification of holdings away from the Dollar, and
4. perhaps the search for less correlated assets.

Given these and other factors, it makes sense for investors to become more aware of the choices that are available to them to include pure currency exposures in their portfolios.

Portfolio Vehicles:

Investors have basically four choices:

• spot market currencies
• futures contracts
• exchange traded funds
• exchange traded notes

For those stock and bond oriented investors who do not wish to open separate spot currency trading accounts or futures trading accounts, exchange traded funds or exchange traded notes are the practical options. In the case of lower volume and emerging currencies, spot market platforms or futures contracts are not readily accessible to, or particularly liquid for, US investors — making the exchange traded route the only practical option.

Because of the financial stability and credit quality issues among banks, we would not purchase any exchange traded note at this time, leaving exchange traded funds the single practical option for those who wish to work through their stock brokerage account.

Current Currency Funds:

Here is a table presenting the principle currency exchange traded funds and notes available in the US today. We only included ETNs for categories that do not have representation in the ETF category. Liquidity is a problem for many of the funds, as the volume information shows.

The “carry trade” fund (DBV) by Deutsche Bank operates a formula-driven strategy based on interest rate differentials, as opposed to the other ETFs which simply hold instruments for the designated currency or currencies.

For investors who do not follow currency markets, and who are not seeking emerging markets exposures, DBV might be a reasonable choice because of its adaptation to changing market conditions. However, in a shock situation like that of Q4 2008, it would probably be easier to understand how to manage risk or take opportunity with straight currency funds.

Emerging Markets:

Emerging markets are becoming interesting to investors for debt as well as stocks. It is no surprise then that emerging market currency funds have also been offered recently.

Here is a view of the relative percentage performance of US Treasuries (IEF duration 6.87 yrs), local currency investment grade non-US country sovereign debt (BWX duration 6.0 yrs) and Dollar denominated emerging markets sovereign debt (EMB duration 6.73 yrs).

Comparative Currency Fund Performance:

Here are two charts that present the 12 most heavily traded currency funds on a side-by-side basis.

click images to enlarge

China:

China’s economy is large, growing rapidly and central to world trade. Some predict that its currency could one day become a global reserve currency. It has strengthened significantly against the Dollar in recent years. With the US as a massive debtor and China as massive currency reserve holder, the relative shift toward the Chinese currency is likely to continue.

China has a long way to go to put its currency on a level playing field in the foreign exchange markets, but when and if they do, it may well become quite active, and potentially popular among investors. It deserves watching.

Here is a currency chart showing the number of Chinese currency units per US Dollar over the past 16+ years.

click image to enlarge

Be Aware of Currency Exchange Rates:

Currency exchange rates have an important impact on corporate profits in a global economy, and a direct impact on non-Dollar debt owned by Dollar-based investors. Those two facts make staying on top of currencies a good idea, even if direct pure currency exposures are not suitable for your portfolio.

Comments

[Analyste de...:]

I jumped on the currency ETF bandwagon relatively early, back in 2006. My experience hasn't been bad, but CAVEAT EMPTOR! with currency funds.

Most investors don't have assets to reasonably invest in spot, and futures contracts are likewise too esoteric for the mutual fund crowd. (Be reasonable.) I'll also exclude large institutional hedgers, bigger clients >$5mln investable assets, gamblers and day-traders from what follows, my own opinion if/how these currency ETF/ETNs suit most retail investors.

For diversified IRA accts and the portfolios of small shop investment advisors, the forex allocation is probably just a TREND TRADE. Currency plays are a much riskier alternative within fixed income: a 3-15% allocation might be suitable for some investors but probably NOT "most." Why?

Consider the RISK carefully : from 7/17/08-10/27/08, FXE lost -21%, FXA lost -38% FXS lost -25%, BZF lost -28%, etc. A second wave of global deleveraging will almost certainly entail similar losses. Those anticipating big equity declines tomorrow shouldn't overweight forex now: once burned, twice shy. Have we learned anything?

These aren't set-it-forget-it investments, people! Given the OLD story of the Dollar's purported weakness, I will continue to use a couple of currency plays going forward, but in 2008 the gain on a prudent allocation was only about 100-150bps over FDRXX (15%, with trading exits, entries and switches.) If 2009-2010 proves so volatile as last year, expect losses with many currency ETFs.

Final assessment:
Given the fractional allocation and constraints on resources (honestly factoring time, due-diligence, understanding & tracking the forex mkts, opportunity costs, etc.) most advisors & long-term investors will likely seek greater alpha for smaller accts elsewhere.

May 28 03:45 PM

[RiskReturnO...:]

I'm long DBV as a core holding in my long term portfolio. Studying the long term performance (going back to before the DBV ETF was available) of the underlying index, you can see that the G10 Carry Trade has averaged 10% annual return, with much less volatility than US market (SPY). For a long term diversification perspective, DBV is a great, low cost vehicle.

From fundamental perspective, DBV plays on the growing China and emerging markets, as the key long position is Aussie $ and New Zealand Kiwi, both commodity producers; and the key short position is Japan Yen. If there is any global growth, DBV will have good upside. If there is NO global growth, DBV will suffer, but much less than US equities.

May 28 04:09 PM

[Richard Shaw:]

Analyste de Boston & RiskReturnOptimizer:

Thanks to both of you. Nice to have thoughtful comments with supporting information or ideas. That's the kind of value added commenting that is so often lacking in comments. I appreciate the time and effort you put into making a contribution that moves the dialogue forward.

May 28 04:27 PM

[Analyste de...:]

I'm reluctant to take fund companies promotional claims at face value. Does your purported long term average annual return (before inception) include ALL costs & taxes?

I also wonder why you'd compare DBV to the SPY, much less consider it a "core holding" (>15%?) If you're an aggressive investor, you also understand that most people don't intentionally share that risk-tolerance.

Considering the NAV alone, DBV lost -26% since 10/9/07, the onset of the Great Bear Mkt. Isn't its performance closer to a junk bond fund? Maybe that's a way to consider suitability for a client or investor : "Would you feel comfortable investing in junk bonds?"

As a "core holding," I very much doubt that's appropriate for most investors.

May 28 04:35 PM

[Richard Shaw:]

Analyste: First, I made no suggestion that DBV be a core holding, or even that any currency fund be a core holding. Second, I always compare all investments to both S&P 500 and Aggregate Bonds just for general benchmarking purposes. Third, I do invest in junk bonds. Fourth, there are no promotional claims from any company in any part of this article. The return data is from Thompson/Reuters, and there is nothing "purported" about the data -- it is the recorded facts, as rendered by Thompson. The data does not take investor taxation into consideration, and there are no charting services of which I am aware that does so, nor do I see the need for that for the purposes of this article. Fifth, this article is not suggesting that currencies in any form are suitable or not suitable to any particular person for any particular purpose -- in fact, this article does not recommend currencies, but rather reports on the rise in their popularity and availability. You seem to take this article to mean and say things that are not meant or said.

May 28 05:27 PM

[Analyste de...:]

Richard, I was responding to RiskReturnOptimizer in my second reply. (You replied before me, out-of-sync.)

I have the greatest respect for your work, and my first Reply was simply an Addendum. I think we're all on the same page, but I do play Devil's Advocate when I see so many articles chasing a hot sector. This one definitely needs caveats.

Someone has to underscore the currency risks, especially when those ETFs are flying and getting "rising interest" no?

May 28 06:04 PM

[Analyste de...:]

Oh, I don't hit "Reply" because I find long, repeat text a huge nuisance to scan. Sorry if this led to your confusion about my 2nd Reply. Thanks!

May 28 06:07 PM

[Alan Young:]

Excellent summary, very useful, and an important and timely topic.

Analyste's point about risk is well-taken, though. What I would like most is a follow-up discussing how to watch for trend changes and control risk--I have the impression that the technique might be different from how you evaluate (and set stops on) equities.

May 28 09:48 PM

[oldman:]

DBV had a large drop in price about a year ago. Its quite unsettling to be in a managed fund like that and get hit like that. Not what I would expect but not interested in owning it now.


On May 28 04:09 PM RiskReturnOptimizer wrote:

> I'm long DBV as a core holding in my long term portfolio. Studying
> the long term performance (going back to before the DBV ETF was available)
> of the underlying index, you can see that the G10 Carry Trade has
> averaged 10% annual return, with much less volatility than US market
> (seekingalpha.com/symbo...). For a long term diversification
> perspective, DBV is a great, low cost vehicle.
>
> From fundamental perspective, DBV plays on the growing China and
> emerging markets, as the key long position is Aussie $ and New Zealand
> Kiwi, both commodity producers; and the key short position is Japan
> Yen. If there is any global growth, DBV will have good upside. If
> there is NO global growth, DBV will suffer, but much less than US
> equities.

May 29 11:53 AM

[Skjellifetti:]

What are the correlations between DBV and the S&P, MSCI, bond indexes, etc?


On May 28 04:09 PM RiskReturnOptimizer wrote:

> I'm long DBV as a core holding in my long term portfolio. Studying
> the long term performance (going back to before the DBV ETF was available)
> of the underlying index, you can see that the G10 Carry Trade has
> averaged 10% annual return, with much less volatility than US market
> (seekingalpha.com/symbo...). For a long term diversification
> perspective, DBV is a great, low cost vehicle.
>
> From fundamental perspective, DBV plays on the growing China and
> emerging markets, as the key long position is Aussie $ and New Zealand
> Kiwi, both commodity producers; and the key short position is Japan
> Yen. If there is any global growth, DBV will have good upside.
> If there is NO global growth, DBV will suffer, but much less than
> US equities.

May 29 02:49 PM

[ikkyu:]

Greetings,

As always, a great overview by Mr. Shaw

To throw my 2 yen into the discussion, I think the carry trade makes sense as a default position for engaging in currency markets. I don't think that is highly disputed among currency experts. Of the three major techniques for trading currencies, valuation (PPP), momentum, and carry, carry has by far the best risk-adjusted returns. Don't take my word for it though. Compare various indices:
https://index.db.com/d...

Also, carry trading really compliments a bond heavy portfolio, as there is a fairly constant negative correlation.

Cheers from Osaka,
john

May 29 07:53 PM

[bettssling:]

A belated question -
Why is SZR shown here as an ETN (debt)?
Wisdomtree markets this fund as an ETF. Have I missed something in the fine print?

Aug 19 10:54 AM

[Richard Shaw:]

bettssling: no you are correct. my data service mislabeled the vehicle type. thanks for the notice.

Aug 19 11:16 PM