Currency-Basket ETF: A Portfolio Imperative

Given the restrictive nature of financial instruments in the emerging markets, the Wisdom Tree Emerging Currency Fund (CEW) stands out in its ability to capture broad and sudden shifts in investor sentiment; the ETF is mandated to access “non-deliverable” forward exchange (NDF) contracts quoted by a number of seasoned market-makers. To the extent that the leading candidates in the emerging markets spectrum are responding to global developments in their own unique manner, the ETF is thoughtfully diversified. Moreover, since this ETF’s policy is to hold securities which are rated (upper two tiers, short term), it is well-positioned to weather a major meltdown.

At first glance, the Emerging Currency Fund may only appear to be of interest to traders seeking to make bets on a basket of emerging market currencies. However, a closer scrutiny throws up many other reasons to engage this ETF.

Retail investors in the U.S. have long eyed the relatively higher returns on short-term money market instruments in the emerging markets; this ETF provides such access without encumbering subscriber funds with potential settlement risks. Of course, the ETF aims to achieve “total returns reflective of both money market rates in selected emerging market countries available to foreign investors and changes to the value of these currencies relative to the U.S. dollar.” So only those who desire exposure to foreign exchange risks should be investing in or trading CEW.

Furthermore, it is important to highlight the fact that NDF contracts incorporate both, interest rate differentials and purely speculative orders; therefore, during periods of stress in the financial markets, the exchange rates available in the over-the-counter NDF market are a much better reflection of reality than official quotations from banks in the emerging markets. And since emerging market currencies rely fundamentally on a basket of currencies (mainly the dollar, the euro and the yen) for direction, CEW can be regarded as a play on the value of the dollar; for example, the ETF’s current holdings (www.wisdomtree.com) are offering an interesting arbitrage window between the dollar and the euro – more on this in a separate post later.

CEW first came to this writer’s attention via a banner ad on Seeking Alpha. Since then, this ETF has become an integral component of our overall trading strategy. At this juncture, this writer is modestly short CEW and is looking to add to shorts on any sharp advances (towards and beyond $23) from recent highs. These shorts reflect the view that the next major crisis in the emerging markets will follow the realization that $400 billion of foreign currency debt on the books of corporations and banks debt needs to be refinanced by the end of the 1^st quarter of 2010.

But, on the other hand, this writer will not be averse to establishing long CEW/short FXE, long CEW/short EU or long CEW/short CNY trades if market conditions so warrant.

Finally, for purposes of clarity, the NDF is essentially an outright forward exchange contract in which profit and loss is adjusted between two counterparties based on the difference between the contracted and the spot rate on the contract settlement date. The NDF market is an over-the-counter market working outside the restraints normally applicable to “in-country” contracts.

Disclosure: Short CEW

Comments

[No Free Cake:]

Interesting stuff as always.

For something like this would have been nice if you'd mentioned it isn't very liquid. Over the past couple of days this ETF has had periods of 20 minutes where no shares trade hands. Even fairly small orders move the price. Certainly don't use "market" orders with this one.

Oct 19 10:58 PM

[Rakesh Saxena:]

Good point. Certainly don't want to move the price when one enters arbitrage trades. Many thanks - R


On Oct 19 10:58 PM No Free Cake wrote:

> Interesting stuff as always.
>
> For something like this would have been nice if you'd mentioned it
> isn't very liquid. Over the past couple of days this ETF has had
> periods of 20 minutes where no shares trade hands. Even fairly small
> orders move the price. Certainly don't use "market" orders with this
> one.

Oct 19 11:06 PM

[Alan Young:]

I'm long this fund, so I appreciate your explanation of its benefits. And, I would really like to understand why shorting would be a better idea, as you claim. With 11 different currencies in the basket, each one is just 9% of the fund. How many of these countries (including Brazil, China, Israel and Singapore) have to have a debt crisis to offset the trend of strengthening currencies against the dollar, plus pay for the cost of margin borrowing?

Oct 20 01:01 AM

[Johnni:]

I was considering using this ETF or UDN as a US$ hedge. Any input on alternatives?

Oct 20 02:33 AM

[Rakesh Saxena:]

Alan: If you are optimistic about a broad economic recovery (global), you should stay long. My view is that banks and corporations in the major emerging markets (many of which are included in this fund) face the daunting task of refinancing foreign currency debt. Of course, as you will see from my earlier posts on this site, I am also generally bearish for 2010. Many thanks - R


On Oct 20 01:01 AM Alan Young wrote:

> I'm long this fund, so I appreciate your explanation of its benefits.
> And, I would really like to understand why shorting would be a better
> idea, as you claim. With 11 different currencies in the basket, each
> one is just 9% of the fund. How many of these countries (including
> Brazil, China, Israel and Singapore) have to have a debt crisis to
> offset the trend of strengthening currencies against the dollar,
> plus pay for the cost of margin borrowing?

Oct 20 08:35 AM

[Rakesh Saxena:]

Johnni: This fund is a good US$ hedge, the alternative being a euro-specific ETF. Many thanks - R


On Oct 20 02:33 AM Johnni wrote:

> I was considering using this ETF or UDN as a US$ hedge. Any input
> on alternatives?

Oct 20 08:36 AM