While there are historically low interest rates in the United States (as well as rates of 0.1% in Japan), many other developed countries, including Australia and Norway, have begun to raise rates as a sustainable economic recovery has taken hold. With virtually all of the major central banks meeting in the next three weeks, currency news will certainly be in focus as 2009 winds to a close, with investors playing the “carry trade” paying particularly close attention.
The carry trade involves a relatively simple strategy: investors borrow in low cost currencies (such as the the yen and the U.S. dollar) and then invest the proceeds in high yielding currencies (such as the Australian dollar). If exchange rates remain stable, investors profit off of the interest rate differential, while an appreciation of the high-yielding currency will further enhance returns. There is, of course, risk of loss if the higher-yielding currency drops in value, a very real possibility in almost any environment.
Historically, playing the carry trade has required establishing both long and short positions in up to a dozen currencies. But the rise of the ETF industry has made this investment play easily accessible to almost every investor. Currently, there are two funds that seek to exploit growing interest rate differentials between developed economies: PowerShares DB G10 Currency Harvest (DBV) and the iPath Optimized Currency Carry ETN (ICI).
DBV tracks the Deutsche Bank G10 Currency Future Harvest Index, a benchmark composed of currency futures contracts on certain G10 currencies that is designed to exploit the trend that currencies associated with relatively high interest rates, on average, tend to rise in value relative to currencies associated with relatively low interest rates.
ICI, on the other hand, tracks the Barclays Capital Intelligent Carry Index. It is designed to reflect the total return of an “Intelligent Carry Strategy,” which, through an objective and systematic methodology, seeks to capture the returns that are potentially available from a strategy of investing in high-yielding currencies with the exposure financed by borrowings in low-yielding currencies.
|New Zealand dollar||33.46%||5.98%|
Both funds hold the G10 currencies (which include the U.S. dollar, euro, Japanese yen, Canadian dollar, Swiss franc, British pound sterling, Australian dollar, New Zealand dollar, Norwegian krone and Swedish krona. Despite having the same basket of currencies to choose from, the funds take a very different approach to investment. (All information as of 11/18/09 and taken from iPath and PowerShares sites.)
As presented in the adjacent chart, there are significant differences between the holdings of the two funds. Most notable is the heavy concentration of DBV into 6 currencies and the large disparity in the holdings of yen. DBV takes a big short position in the Japanese currency, while ICI is actually long.
Another interesting difference is the avoidance of DBV of the currencies of Europe, save for Norway and Switzerland. In addition to focusing on three of the main commodity producers on the list (Australia, New Zealand, and Norway), DBV seems to be more heavily invested in the true high-yielding currencies, while ICI takes a more forward looking approach. It invests in currencies that have just recently raised rates, such as Australia and Norway, as well as investing in countries that may raise rates in the near future, such as Japan and New Zealand.
In addition to major differences in holdings, these two products have a very different structure: DBV is an ETF and ICI is an ETN. This seemingly minor distinction means that ICI will have reduced tracking error, but will expose investors to the credit risk of the issuing firm (in this case Barclays, which is currently rated AA-).
Performance & Expenses
DBV has outperformed ICI both in 2009 and over the past 52 weeks. DBV has gained 20.4% in 2009 and 18.7% over the past 52 weeks, while ICI is up 4.9% and 3.1%, respectively, over these periods. However, DBV has a higher expense ratio, coming in at 0.75% compared to ICI with 0.65% and DBV has been more volatile than its ETN counterpart recently thanks in large part to its concentrated holdings.
With a reversal of the easy money policies likely in the next few years, these two funds could benefit from continued global diversity in interest rate levels. As some nations begin to focus on combating inflation while concentrate on stimulating national economies, opportunities to play the carry trade may become much more attractive. DBV and ICI both offer efficient ways to potentially exploit the exchange rate trends that come from these monetary policy decisions and resulting interest rate levels, albeit in completely different ways.
For investors who are fearful of high volatility and looking to minimize expense ratios, ICI may be a good choice. However, if you are wary of the ETN structure and want a pure carry trade play that offers superior returns, DBV may the fund for you.
Disclosure: No positions at time of writing