Eye on Currency Impact and ETFs

By Jim Wiandt

Matt Hougan's data underscores what we all know intuitively - that currencies often drive returns.

Currencies, like commodities, are very interesting creatures in the investment world, because they don't go to work, they don't make money and they have no expected growth rate. In fact, if you look across the spectrum of global currencies, it's a ZERO SUM game. For every winner, there is a loser, and for every loser, there is a winner. So does that mean we should just ignore currencies and commodities?

That would be a resounding "no."

The reason is that it behooves you to be as diversified as you possibly can be ... as a way to add some ballast to your holdings and protect your portfolio against volatility. So for those of us (and the data say it's most of us) who have had a very highly dollar-weighted portfolio over the last few years, have felt the pain over the last few years, despite the fact that markets overseas have NOT raced by the U.S. in (local-currency-weighted) returns. If U.S. investors had held portfolios more in line with global market cap, that euro (and other currency) exposure would have taken care of itself. See Matt's data from last week if you need a more vivid accounting.

Revenge of the Dollar

Now, however, perhaps, PERHAPS the tables have been turned. Consensus seems to be that the U.S. may be nearing the bottom of the latest economic cycle, while European and other economies are only beginning to feel the pain. While I expect some short-term dollar (read, this week, maybe) bearishness in the wake of the spectacular recent run-up, it does feel it may be the dollar's time.

This doesn't necessarily mean you should go out and scramble your portfolio (in fact, please don't), but it's something you should be aware of as you look to rebalance.

Harvesting Yield Differentials

Speaking of rebalancing, one of my favorite ETFs (though I do not own it) is DBV, the PowerShares DB G10 Currency Harvest fund. This is one of the most interesting funds to look at, too, when we're talking currencies. And this fund is the essence of a long-standing institutional strategy gone retail in an ETF. Basically the fund is long currencies that have high yields and short currencies with low yields. The idea is that currencies with high yields tend to rise vs. currencies with lower yields. Traditionally, the results of the strategy have been stellar, with high returns and relatively low volatility.

Not so this year, though it has still bested much of the market. The fund was at around $27 a share a year ago, topped out at around $30 a share and recently has drifted from $27 a share down to $26 a share. In early 2007, DBV was long the U.S., Aussie and Kiwi dollars and short the Japanese yen, Swedish krona and Swiss franc. Right now, it's still long the Aussie and NZ dollars and the Norwegian krona and now is SHORT the U.S. dollar as well as the yen and Swiss franc. Of course, being short the dollar over the last week or two has NOT been the place to be, but you'll drive yourself nuts looking at this fund day to day. But it IS entertaining and I think sheds some interesting light into currency markets.

Next up for ETFs? The Carry Trade ETF. Who's on that one, Matt?

Emerging Markets Currency Effect

All of our blogging last week really neglected talking about emerging markets currencies, the effects of which have been relatively flat vs. the U.S. dollar (again, see Matt's data to see what I mean).

One of our readers had some interesting thoughts on this and the potential trends going forward in an mail he sent us last night:

"One interesting aspect worth noting on the dollar front is the very possible (if not likely) divergence in between developed and emerging market currencies relative to the dollar --- and, of course, what that implies for U.S. investors in those markets' equities, in dollar terms. With Euro-market GDP growth grinding to a halt, and a significant softening in other developed markets, we should still see strongly positive GDP growth in most emerging markets as those economies have come to generate significant and growing internal consumer demand bases that simply didn't exist five or ten years ago. Is that same emerging market GDP growth sensitive to developed market conditions? Of course it is. But, still, think about it ... Emerging market GDP going from, say, 7-10% to 4-7%? Developed market GDP going from 2-3% to 0-1%? Still not a "fair" horse race in GDP growth rate-wise.

What it all means is that with developed market economies performing more or less as poorly as ours, a retracement of dollar rates to levels preceding those of last summer when many thought the U.S. economy had a gun pointed only at its own head. But on the dollar vs. emerging economies' currencies --- not so sure that we'll see the same fate - or at least to the same extent or severity. Further, a softer dollar vs the other "majors" also means cheaper dollar-denominated energy for all. In the end, U.S. investors in foreign equities might not suffer to the same extent from exchange rate impacts of the dollar vs. emerging market currencies as the dollar vs. Eurozone and other developed markets currencies.

I might be all wet on this one, but I'd bet on emerging market currency performance relative to the dollar more than I would developed market currencies over the next 6-12 months. We certainly have plenty of excitement before us. Thank you for the articles!"

At a certain point, thinking forward on these issues gets to be a crap shot, but the (anonymous) reader's observations seem to me to make sense. Still, I find there's some irony to this because of the fact that there's been such a strong currency run-up and the EM currencies (EM is of course very exposed to commodities pricing) don't seem to have reaped the full benefits. But that (possible) lag and the room for growth seem to make the readers case.

Anyway - some food for thought. I think I'm all currencied out for now. But these seem like issues worth talking about.

Comments

[alpha24seven:]

Hey "Mr Germany" So which hedge fund/PE fund with $billions AUM (sorry Deutsche Marks, because the Germans are "tired" of the Euro) did you say you run again? I mean with your level of technical expertise in all things market and you incredible investing record -- the "pikers" must be throwing money at you to run, right?

lol...

2008 Aug 18 04:51 PM

[Georgey:]

I wonder why volume is so low on the China currency cny and cyb symbols .

2008 Aug 21 12:29 PM