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When I wrote my blog entry on currency ETCs yesterday, I wasn’t aware of the various carry-trade products available on US exchanges. But after a very informative conversation with Morningstar’s Bradley Kay this morning, I’m now much more up to speed. And while there’s nothing in the US quite like the UK products, there are still a fair few carry-trade vehicles to choose from.

First though, it’s worth looking at some well-established ETFs which are very bad ways to play the carry trade: the Currency Shares suite of ETFs which aim to mirror the performance of nine different currencies. Of those nine, six pay essentially no interest at all, and the amount of interest they pay is basically at the discretion of Currency Shares. “They should be paying interest,” says Kay, “it’s only when I run the graph and I look at them that I say wow, over periods when there should be positive carry, there’s really nothing there.”

The Currency Shares ETFs, then, are a good way to make a short-term bet on currency movements. But they’re not a good way to play the carry trade in particular, which involves taking advantage of the higher interest rates available in foreign currencies.

Then there are a couple of funds which are simply plays on the direction of the dollar. The PowerShares dollar index funds (UUP is bullish, UDN is bearish) are based on futures, and therefore do accrue local-currency interest in much the same way that the ETCs do. But they’re fundamentally trading vehicles designed to make bets on the direction of the dollar, not to use low dollar interest rates to fund investments in foreign currencies.

Finally there’s a pair of funds which specifically seek to replicate the carry trade — the PowerShares G10 Currency Harvest fund (NYSEARCA:DBV), and the iPath Optimized Currency Carry fund (NYSEARCA:ICI). Both of them use futures to capture the full local-currency returns: they’re true carry-trade plays.

There are differences between the two, most notably that DBV is a true ETF, where shareholders own shares in a trust. ICI, by contrast, is an ETN, which means that shareholders are essentially just unsecured creditors of Barclays, who don’t get paid for taking on the Barclays credit risk.

They invest in slightly different things, too: DBV takes the G10 currencies and goes long the three highest-yielding currencies while going short the three lowest-yielding currencies. As a result, it’s either 2x leveraged (if the dollar is not one of those six currencies) or 1.66x leveraged if the dollar is part of the mix. The results can be highly volatile: in the second half of 2008, the fund fell over 30% as the yen (one of the shorts) rose and the Aussie and NZ dollars (the longs) fell.

DBV then is very much a trading vehicle, rather than an investment vehicle. Over the long term it does tend to generate positive returns, and those returns tend to have a nice low correlation with most other asset classes. The problem is that when you really need diversification — when people are panicking and stocks are plunging — is likely to be exactly the same time that this strategy blows up as well, as investors flee risky smaller currencies for the safety of the low-yielding dollar.

ICI is much more conservative, carefully selecting G10 currencies to invest in so as to maximize carry while minimizing volatility. It’s also cheaper than DBV, charging 65bp rather than 75bp per year. But it’s tiny, with a market capitalization of less than $30 million, so I’d stay away for the time being.

And there’s one more fund worth mentioning: the WisdomTree Dreyfus Emerging Currency fund (NYSEARCA:CEW). It too is quite small, but it invests in all manner of exotic high-yielding currencies, and it’s performed quite well: Kay gives it credit for avoiding the zloty crash. If you really want to play the carry trade, this might be worth a look.

Source: How U.S. Investors Can Play the Carry Trade