Six Ways to Trade Foreign Currencies

Trading opportunities in the foreign exchange market have expanded rapidly this year. In February Merrill Lynch and partners introduced five new currency ETNs, followed in March when Van Eck/Morgan Stanley brought four of their own. Then, in May, Wisdom Tree got into the picture with five new ETFs. These developments, along with some new wrinkles on packaged strategies , inspired me to update my earlier note in February on trading currencies (here). Here’s a brief rundown on what’s new in this corner of the exchanged traded world.

By way of review, the eight currencies offered by Rydex and described earlier, are a straightforward way of dealing in foreign exchange. You choose the currency you want to own, and buy (or sell short) the appropriate ETF. Rydex then buys that amount of interest bearing account and short-term, investment grade paper denominated in the local currency. Simple and relative inexpensive, I like this approach, especially because you earn monthly interest at rates prevailing in the host country.

1. Rydex ETF and Interest Rate

• Currency Shares Australian Dollar Trust (FXA): 6.71%
• CurrencyShares British Pound Sterling Trust (FXB): 4.66%
• CurrencyShares Canadian Dollar Trust (FXC): 2.48%
• CurrencyShares Euro Trust (FXE): 3.81%
• CurrencyShares Japanese Yen Trust (FXY): 0.23%
• CurrencyShares Mexican Peso Trust (FXM): 7.04%
• CurrencyShares Swedish Krona Trust (FXS): 3.79%
• CurrencyShares Swiss Franc Trust (FXF): 1.35%

2. PowerShares has not changed their lineup of three trading strategies.

• A dollar bullish ETF (UUP) which goes long on the Group of 10 Currencies.
• A dollar bearish ETN (UDN) which shorts the same currencies that the bullish index follows.
• DB G10 Golden Harvest Fund (DBV) which divides the Group of 10 currencies into low interest rate countries and high interest rate countries. They then borrow money in the low interest rate currencies and use the proceeds to buy long positions in the high interest rate currencies. They use a Deutschbank Index that specifies which to borrow and which to buy.

3. Wisdom Tree began trading four currencies on May 14:

• Wisdom Tree Interest Rates
• Chinese Yuan (CYB) 0.7%
• The Euro (EU) 4.3%
• Brazilian Real (BZF) 11.9%
• Indian Rupee (ICN) 6.5%
• Japanese Yen (JYF) 0.7%

Interest rates used for Wisdom Tree come from their published source. Rates for Australia, Canada, the Euro and Japan reflect the London Interbank rate for 1-month deposits in various currencies. LIBID rates are the daily reference rates at which a consortium of British banks are prepared to accept deposits. For Brazil, India and China, the implied yields for 1-month non-deliverable forward contracts were used to replicate the rates achievable by U.S. investors. These rates can change on a daily basis, so they can’t be used for long term planning.

The Euro and the Yen ETF are quite similar to those offered by Rydex. They buy the target currencies and hold local interest-paying instruments, and they pay dividends quarterly or annually. But, Brazil, China and India are emerging markets, and the commercial short-term paper in these countries is not as liquid as needed for an ETF. Wisdom Tree fixes this problem by buying short-term financial instruments denominated in dollars, and then using these instruments as collateral to fund currency futures contracts in the target currency.

I was especially pleased to see these new emerging market currencies offered through an ETF. These are not the usual suspects, so to speak, and Wisdom Tree took some risks with their decision. These are three of the world’s fastest growing economies, and they have had little to no representation in the exchanged traded world until recently. These are big holes that needed filling.

The next three providers use exchange traded notes [ETN] as their form of “ownership.” I use this term advisedly, for with an ETN all you own is an account receivable for an uncertain amount.

4. The oldest currency ETNs are from Barclays and are known as iPath Exchange Traded Notes, most of which were introduced in May, 2007.

Barclays ETNs

• Euro (ERO)
• Pound Sterling (GBB)
• Japanese Yen (JYN)

A carry-trade device (ICI) that borrows money in low interest rate currencies and buys futures in the high interest rate currencies, similar to the PowerShares ETF, DBV, covered earlier. However, Van Eck uses a Morgan Stanley Index to determine borrowing and buying decisions, so their borrowing/buying decisions are not necessarily identical to the PowerShares product.

5. Elements, a new entrant sponsored by Merrill Lynch, began selling their five currency ETNs in February.

Elements ETNs

• Australian Dollar (ADE)
• Pound Sterling (EGB)
• Canadian Dollar (CUD)
• Euro (ERE)
• Swiss Franc (SZE)

I can’t give them many points for originality in their offerings—choosing the usual suspects in currency trading. Of course, in their defense, these are the currencies that are reliably traded all over the world.

6. Van Eck/Morgan Stanley also began selling currency ETNs on March 14 of this year.

Van Eck

• Chinese Renminbi (CNY) (The new, official name of the Yuan)
• Indian Rupee (INR)
• Double Long Euro (URR)
• Double Short Euro (DRR)

They will be offering two other “double” ETNs soon.

• (UYY) for Double Long Yen and
• (DDY) for a Double Short Yen.

How have these currency trading approaches fared in the marketplace? It’s too early to tell with much conviction, but there is some preliminary evidence that gives us a glimpse at how the market is reacting their various products

From early trading volumes I am impressed with Wisdom Tree’s success. The Yuan and the Real are especially strong, both having sold over 80,000 shares per day for the first four days.

iPath ETNs have done better than Elements ETNs, but neither have done as well as Wisdom Tree.

More instructive are how the long and short instruments are doing. If we take the trading volumes as indicative of investor sentiment, the market is now bullish on the U.S. dollar—a complete reversal from late last year. The Double Short Euro/USD is almost 30 times as popular as the Double Long Euro/USD. PowerShares’ US Dollar Bearish Fund has about 1/14 the trading volume as the Dollar Bullish Fund.

The question yet to be answered is, Should you hold currencies in your portfolio? For many years currency trading was left to the professionals—people who bought and sold foreign currencies for their customers—large banks who had clients dealing with foreign buyers or sellers. Yet the benefits of a well diversified currency portfolio as part of your total holdings are well known. Currency movements, like commodities, move to their own drummer, so currency holdings act as a counter-cyclical force—helping your portfolio’s stability in bad times.

A couple of charts will help demonstrate this point. I have only a limited number of pairs that can be shown because of the limited number of countries that have their currencies traded with ETFs or ETNs. But, we can look at several and learn from them.

The first chart is the performance of the Mexican broader market, as exemplified by iShares’ (EWW) which is uses to the Morgan Stanley Mexico Index. I pair the performance of this ETF, which is somewhat representative of how the Mexican stock market faired over the last couple of years, with Rydex’s Mexican peso fund, FXM .

Mexican Peso vs. Mexican Equities Market

2-Years

Here you can see how well the Mexican stock market did, coming in with a 60% rise over two years. Yet the peso barely moved over the entire period. This is because the Mexican central bank tightly controls the value of the peso. The U.S. is their largest trading partner and they want to maintain parity with the dollar. Investors can probably count on this policy into the foreseeable future—the greatest danger of this type of manipulation is that the dollar and the peso get into fundamental imbalance, in which case there will eventually have to be a major de-or re-valuation. This chart is a price chart only, so not seen is the 7% interest accumulation that a holder of the peso would have earned over the period shown.

Next, look at Japan—another country that is often accused of manipulating the value of the yen to its own interest.

Japanese Yen vs. Japanese Equities Market

1-Year

I can only show one year in this chart because the yen has not been trading much more than a year in an ETF. But here the picture is the reverse of the Mexican peso. The Japanese stock market has not done well the last year, having lost almost 10%, yet the yen has appreciated over 15% during the period. The reason for yen appreciation is not attributable to the Japanese manipulation as it is to the world-wide fall of the value of the U.S. dollar. The Japanese have not attempted to follow the dollar down, so a currency holding of the yen paid off much more than holding Japanese equities.

The last chart shown is for Australia.

Australian Dollar vs. Australian Equities Market

2-Years

Here we have the opposite between Mexico, which has a growing economy and a stable peso, and Australia with a growing economy and a growing AUS dollar. Again, the increase in the value of the Aus $ is partially attributable to the fall of the dollar. But, the Australian economy is dependent to a large degree on commodity prices, and, as we all know, commodity prices have skyrocketed over the last two years. So much so, that they have taken the Australian economy and its currency with them. Obviously, the Aussies did not try and maintain a peg with the U.S. dollar, since their major exports are in the opposite direction, to China and the far east. In this instance, a holder of the Aus$ would have had a good return, enhanced beyond what is shown in Chart 3 by having earned a high rate of local interest earnings.

Remember that you also get a broad currency exposure if you own any international equity shares and/or un-hedged foreign bond holdings. If you own these types of instruments, then you have plenty of currency exposure. To reveal my own positions, I currency hold FXM, the Mexican Peso ETF, and I use it as something akin to a money market fund. I also recently added a small position in the Brazilian Real currency fund offered by Wisdom Tree (BZF). Like Mexico, Brazil has a high internal interest rate that I hope to capture.

Next time I will go more into specific trading strategies that have recently come to market, some of which have been covered today. But the most innovative strategies come from some of the old-line Forex trading platforms, and they deserve an explanation of their own.

Comments

[User 178949:]

Very interesting article but I would appreciate your opinion of the relative merits of each etf when considering fees. Your future discussion of the various strategies being employed also sounds promising.

2008 May 30 09:13 AM

[SA2:]

What about the tax implications if held in a taxable account?

Thank you.

2008 May 30 05:23 PM

[Ray Hendon:]

The expense ratios are important, but with currency funds they are far from the complete story. Also check the bid/ask spreads among the various vendors and the spread between the interest earned and interest paid. Rydex and Wisdom Tree have the lowest ERs, although Elements are also about the same as Rydex. Van Eck is the highest, with a .55% ER. But, recall that ETNs all have futures to buy, and the costs of futures are not included in the overall expense ratio.

In terms of tax implications, the interest earned on ETFs and ETNs is taxable for the year in which it is either paid or declared. But, with ETFs, you at least get the dividends. With ETNs they are added to the total value of your investment but are not paid our. You must sell the shares to capture them, and you must pay the tax on them even though they are not paid out. To me, this gives an edge to ETFs.

2008 May 30 09:37 PM

[Sam:]

From the article, it appears the only ETF you are recommending is the DBV which does the carry on trade. currencies move very slowly with small incremental changes. So will a ETF capture these movements effectively?

2008 May 30 09:47 PM

[granger:]

Nice article. Discloure I own the DBV and recently added small amounts of CYB and BZF. I also hold numerous foreign bonds, specifically from Sweden and Switzerland. Thanks for the summary.

I am definitely interested in this areas. I currently target about 15% of my portfolio to currencies.

What allocation have others used? overall cuureency thoughts and strategies?

2008 May 31 07:28 AM

[Ray Hendon:]

Sam, I haven't made any specific recommendations about individual ETFs or ETNs, except that I own two. The reason I don't make specific recommendations for an investor is that what they buy must depend on what their current exposure to currencies are, among other considerations. For example, granger, in the last comment, has exposure to several European currencies through bond holdings. So, he would not need to have those currency ETFs in his portfolio unless we was shorting them to hedge his bond bets. I simply do not believe that every investor needs to have currency exposure, depending on their attitude about and ability to handle risks.

DBV is a strategy ETF, and I will cover the strategy possibilities in my next post. Note, however, its high expense ratio. Any strategy will come at a cost, so it is a personal questions as to whether the cost is worth it.

Also, I think ETFs and ETNs do properly reflect the small currency movements on a daily basis, depending on how much they trade. It may be some days before the latest price movements are reflected in NAV if the ETF is not trading. But, over the long run, price movements in the currency will be captured.

Granger, good question about proper allocations of currencies to a portfolio. This is not an area that has gained much attention from financial advisors, for currencies as an asset class have not reached critical mass yet, in my opinion. I think that with the new offerings, however, advisors will begin looking more closely at this area.

2008 May 31 09:14 AM

[jerry on hi...:]

Wisdom trees new offerings look great. I've been looking for such instruments.I tried to look up the brazilian ?etf but couldn't find a trading symbol. HELP.

2008 May 31 01:20 PM

[Ray Hendon:]

BXF is the trading symbol. It has been actively trading since May 14, 08.

2008 May 31 06:19 PM

[bsharvy:]

BXF doesn't exist on Schwab, finance.yahoo.com, or fool.com.

2008 May 31 08:18 PM

[Ray Hendon:]

My mistake. The symbol is BZF.

2008 May 31 10:32 PM

[SA2:]

Thank you Ray for the very informative analysis and your comment about tax implications.

I learned this the hard way - I held DBV and DBA in a taxable account for a short period in 2007 and sold for no gain. At the end of the year I got a K-1 form which was difficult for me to report correctly and the worst of it was I was allocated and taxed for earnings that I did not make. Very frustrating. I will not touch these future-based funds again and from your comment I gather that this is a problem with all ETNs. Buyer beware.

As per your comment the Rydex/Wisdom Tree ETFs seem better, the interest will be taxed as regular income but at list I will only be taxed for money I actually receive and will not need to deal with a K-1 form.

SA2.

2008 Jun 01 01:59 AM

[davidp:]

I'm an ETF newbie, but I expected that ETF would report income/gains on 1099's, not K-1's. Can people with more experience comment on which they are getting? Is there a difference between ETF's and ETN's?

--Dave

2008 Jun 27 07:47 PM

[Georgey:]

CNY ive held since initial offering and its basically flat while my everbank renembi account so far increases about 1% a month .
Wish I could explain or better wish Van Eck could. Market nerves about backer Morgan Stanley ?

2008 Jul 07 12:40 PM