Finding Your Comfort Zone with Currency Investing

Exchanged traded funds have changed currency investing in a fundamental way.  Now, with ETFs and ETNs, the general investing population has a chance to hold international currencies.  They can buy them through their regular brokers without leverage at prices they can understand.  This has greatly expanded the use of this important asset class, and, in my opinion, will change the recommended mix of asset allocations in the future.  It has simply made the benefits available to the little guy, that were once accessible to only the few.

Although currency trading is an ancient practice, the current era began in 1972-3.  After decades of fixed rates under the Breton Woods Agreement, most of the world's currencies broke free from gold and the U.S. dollar and were allowed to float.  Trading took off like a rocket: today, the forex market is estimated at about $3 trillion a day.

But forex trading is not for the casual investor.  This enterprise, like its cousin commodity trading, is the domain of specialists--specialists with big bucks and a tool chest filled with complex trading strategies. It is still common in this industry for many traders to close out their positions by the end of each trading day.  Conventional investors, who buy and hold their portfolio for longer terms, are simply not suited for this fast moving, highly leveraged environment. 

The big day for small investors came on December 9, 2005.  On that day Rydex Investments brought the first currency ETF to market, CurrencyShares Euro Trust ETF (FXE), trading in the U.S. dollar/Euro pair.  The early success of FXE was remarkable.  On the first day of trading it listed over $17 million in assets.  A month later it had $102 million.  It now holds around $2 billion in assets.  It was clear then and even more so now, that currency buying and selling was ready for a conventional pooling/trust type of structure.  The door had opened for the little guy to get a piece of the action.

Its early success of FXE was quickly followed up by Rydex, who brought out six other currency pairs within the following month.  Its last offering, the Japanese Yen ETF (FXY), was introduced in February, 2007.  They have also recently announced some additional pairs to be brought to market soon. 

The first table below shows how Rydex has faired since their first efforts in 2005.  These data come directly from the provider and the assets are listed in millions of dollars under management on June 30, 2008, as do all the tables that follow.

The next ETF provider to jump on the bandwagon, as it was soon to become,  was PowerShares.  Their DB G10 Currency Harvest Fund ETF (DBV), a G10 Carry Trade ETF bundle (managed by Deutsche Bank), was launched on September 18, 2006.  In February of the following year PowerShares brought their Dollar Up (UUP) and Dollar Down (UDN) ETFs to the currency market. 

The carry trade idea was, itself, a significant innovation in currency ownership.  It was the first strategy ETF in the currency market and now has over $500 million in assets.  It has earned third or fourth place in size (depending on the day you look) behind Rydex’s  euro (FXE) and yen (FXY) ETFs.  Its rival for third is PowerShares’ own Dollar Up ETF (UUP). 

Barclays introduced three ETN currency products just over one year ago.  In January they completed their current lineup with a carry trade ETN.

Merrill Lynch/Deutsche Bank introduced their Elements ETNs in February of this year.  Elements have not done well.

About one month later, Van Eck/Morgan Stanley followed suit with four ETNs of their own.   Kudos to Van Eck for innovative ideas and for expanding the risk level available to currency buyers.

In May of this year, Wisdom Tree brought out their first five currency ETFs, and by June had introduced two more.  Their success has been nothing less than spectacular.

Finally, within the last weeks, Barclays has added two additional ETNs that are specialized bundles of currencies that do not have the iPath name: The Barclays Capital Asian and Gulf ETN and their Emerging Markets ETN.  I could not locate their assets under management figures.  Both are less than a month old.

There are now 12 currency pairs available for holding plus a number of specialty bundles and strategy accounts.  It looks as if this small niche of an industry has a long way to go before it matures. 

From the data, a couple of things stand out.  First, the ETF format is trouncing the ETN alternative.  Wisdom Tree’s ETFs, brought to market a year after Barclays iPath ETNs, already have three times as many assets iPath’s.  Elements, out in February of this year, has yet to achieve $10 million in assets.  Van Eck’s ETNs have done better.  Introduced in March, they have $87 million under management, with most of the action coming from their Renminbi offering.  But, here again, the ETF of Wisdom Tree’s yuan fund has more than three times the Renminbi holdings.

The popularity of the big five trading pairs is also apparent:  Euro, UK Pound, Japanese Yen, Canadian dollar and Australian dollar.  Yet, some of the greatest success has been achieved by those who brought new pairs to market.  For example, the yuan/Renminbi and the Brazilian real have been good to their providers. 

Another trend is that bundles and strategy accounts are finding success.  For PowerShares, bundles and strategy are all they have.  I like Barclays’ lineup, too, which has some of both individual country money and strategy funds.

What has accounted for the success of this new format?  In my view, the largest single factor is the attractiveness of the pooling structure available to exchange traded products.  It is simple, easy to understand (except for ETNs) and execute.  This, and the absence of leverage, makes for a more stable price structure and a more attractive investment product than a currency trading account.  The comfort level of currency holding has risen with this new format.

Furthering the comfort levels’ rise is the way exchanged traded products treat interest earnings.  Foreign currencies in the ETF and some ETN formats are treated more as money market balances.  This brings dividend earnings into play, making them more attractive than pure commodity pools that hold and store their assets in warehouses.  Currency accounts may be invested in either local interest bearing paper or, if local liquidity is a problem, suitable paper in more developed markets.  Either way, your money is at work rather than sitting idly in a warehouse, incurring storage charges.

It seems to me that there is some movement of the advisor community towards accepting currency ownership as a proper constituent of a well balanced portfolio.  But, currency investing holds no place in the minds of many advisors, since it was not in the original Fama-French study of asset class allocation.  Probably some new academic work in this area would possibly bolster currency as a proper holding for many investors.

It is also apparent that within the last couple of decades, international investing has become more popular.  It is well within my memory that traditional financial advisors did not recommend foreign holdings in their client’s portfolios.  But now, that has changed.  The U.S. GDP and equity capitalization as a percentage of the world’s totals have dramatically dropped to well below 50%, so investors  need to look elsewhere for balance.

An additional factor in the popularity of currency investing is the wide range of risks that characterizes foreign currencies.  If one has a large appetite for risks, there are many currencies that meet that criterion, and vice versa.  Long, short, double long, double short, pegged, un-pegged, stable, volatile: there are risks levels for everyone.

Finally, the last of the contributors is the growth in the number of currencies and bundles available to trade.  As the data show, new currency pairs are being offered with regular frequency. As a sub-category, strategy bundles have their own attractions,  making the carry trade and other strategies available to an average investor, and their offerings are increasing in number.

Overall, the new kid on the block looks good in terms of assets under management.  I totaled those listed here at $8.8 billion as of June 30^th.  Rydex has about 50% of the total, but this will most likely decline as the new entrants mature and newer ones are brought to market.  It is exciting to experience the evolution of this new wrinkle on an old practice. 

Disclosure: Author owns three currency products: FXM, BZF and FXA.

Comments

[MattFS218:]

I'm curious as to how you got the asset amounts for the tables above. Since these are ETFs, can one take the current Market Cap as total assets?

2008 Jul 07 09:32 AM

[Ray Hendon:]

For ETFs the providers list their assets under management on a daily basis. For ETNs they list the indicative value, which is the last price per share times the number of shares outstanding.

Best wishes,

Ray

2008 Jul 07 09:47 AM

[omsdds:]

Ray,
I bought CNY on 4/17 @40.11 and it is now 39.78 RatesFX yuan value for 4/17 was 7.18812 and on 7/04 was 6.86425 The yuan has appreciated 4.51% while the ETN has depreciated 0.82% Very poor correlation between cash and ETN

2008 Jul 07 01:39 PM

[Ray Hendon:]

I haven't been following CNY, since I detest most ETNs, and your report reaffirms my view on this instrument. I believe CYN is one of the ETNs that doesn't pay dividends, so the interest income, if any (and the Chinese Yuan is the last place I would go to earn interest) you will see only to the extent their forward contracts include any such accumulation. Apparently they are not. The reason for this, I believe, is that China pays less than 1% on their foreign deposits, so that precludes leaving any money there. But, even worse,the yuan is mostly traded through forward contracts which the providers "hope" will include some interest earnings. But, you can't prove that by me--especially with most ETNs.

Also, even Wisdom Tree, whose yuan fund I like more than Van Eck's, only pays dividends on an annual basis--if I recall this correctly. China is not a good place to play the carry trade.

I thank you for your post. Our readers need to know how these differences will affect them and their investments.

Best wishes,

Ray

2008 Jul 07 02:53 PM

[sawgill:]

Thanks for this timely and comprehensive report!

2008 Jul 07 05:56 PM

[Les Mitchell:]

Ray: Is there any good, reliable, non-biased research available (at a reasonable cost) for currency EFT's. I'm a novice and have been unsuccessful in my limited amout of trading experience, but would like to learn.

Les

2008 Jul 08 01:33 PM

[Ray Hendon:]

Hi, Les,
I am not aware of much research on currency ETFs. They are probably too new to attract much attention from analysts. However, even if they were I would be skeptical of their opinions. I'm equally skeptical of my own. No one can do much of a reliable prediction in this type of market, in my opinion. Things can turn on a dime at the slightest quiver of a wind from any direction.

I have read a book on trading currencies, and I thought it was fairly good. Remember, all we have are opinions, and currency trading (vs. investing) is not necessairly a teachable subject. The book I read is : Getting Started in Currency Trading by Michael Duane Archer. It is probably out of print, but I found a copy at Amazon. Also, there are a couple of authors who contribute to Seeking Alpha. Chen and Lieu (if my spelling is correct) are two you might check on.

I would encourage you to approach this subject with the greatest caution, and consider, instead, currency investing--something like the carry trade. Trading is fast paced and will eat you up fast if you are not exceptionally able to cope with it. Few are!

Good luck.

Ray0

2008 Jul 08 09:42 PM