A Peek Under the Wisdom Tree

A mistake is often a good place to start a quest. My recent article on WisdomTree's new currency ETF (CEW) (WisdomTree's New Bundle of Joy) contained the assertion that it was, to my knowledge, the first actively traded currency ETF. Soon after the article appeared, another Seeking Alpha frequent contributor, Tom Lydon, mentioned in a follow-up note that the SEC had classified all of WisdomTree's currency ETFs as actively managed. 

His statement was correct, yet I didn't consider their single currency ETFs as actively managed simply because the SEC must classify every ETF registered under the Investment Company Act of 1940 as either indexed or active. Since no single currency fund can be indexed, therefore, by definition, it must be active. At least that was my reasoning that led me to see CEW as the first actively managed fund. It is slated to come to market late this month with ten currencies in its portfolio, and the countries that are in the portfolio can be varied, according to the manager's discretion.

A day after my article was published, I got word from Seeking Alpha that the press relations person at WisdomTree was asking to speak to me so they could discuss the article. I was glad to accommodate their request, wanting to get to the bottom of the issue. We quickly resolved it over the phone; he didn't feel that any additional clarification was necessary about the article. 

But, he added, perhaps I should speak with their President and COO, Mr. Bruce Lavine. He had views on the structure of WisdomTree's ETFs that he thought would be helpful in differentiating their products from those of their competitors and could explain more fully the implication of being classified as active. I was happy to have such an opportunity, so I readily agreed to an interview, if Mr. Lavine was willing. An arrangement was made for us to speak the next morning, Tuesday, September 16. 

Before the call, the press room provided me with a short background on Mr. Lavine. He earned  a Bachelor of Science degree and MBA from the University of Virginia. He came to WisdomTree in 2005 from Barclays (BCS) where he had first been Director of Product Development in the United States, then in London, where he headed up the European ETF business. He holds the Chartered Financial Analyst designation.

The call came the next morning, and we spent an hour discussing the investment philosophy of WisdomTree and details about how they see the currency market and their place in it. The following is a summary of our conversation:

For my first question I was going to ask for his overview of the currency ETF market and if he saw WisdomTree as a major player in the future. But, before the interview, I took the time to review their recent filings with the SEC for new currency products. The list below was a sufficient answer itself. I told him at the start of our conversation that in reviewing the 25 new funds in their filing, it was obvious they were looking to be the major player, so I didn't need to ask that question. He laughed with me on that statement and agreed that the currency market is important to them. Here is the list of their recent filing:

 WisdomTree Dreyfus Chilean Peso Fund

WisdomTree Dreyfus Czech Koruna Fund

WisdomTree Dreyfus Hong Kong Dollar Fund

WisdomTree Dreyfus Hungarian Forint Fund

WisdomTree Dreyfus Israeli Shekel Fund

WisdomTree Dreyfus Icelandic Krona Fund

WisdomTree Dreyfus Indonesian Rupiah Fund

WisdomTree Dreyfus Malaysian Ringgit Fund

WisdomTree Dreyfus Mexican Peso Fund

WisdomTree Dreyfus Norwegian Krone

WisdomTree Dreyfus Polish Zloty Fund

WisdomTree Dreyfus Russian Ruble Fund

WisdomTree Dreyfus Singapore Dollar Fund

WisdomTree Dreyfus Swedish Krona

WisdomTree Dreyfus Swiss Franc Fund

WisdomTree Dreyfus Taiwan Dollar Fund

WisdomTree Dreyfus Thai Baht Fund

WisdomTree Dreyfus Turkish Lira Fund

WisdomTree Dreyfus BRIC Currency Fund

WisdomTree Dreyfus Developed Currency Fund

WisdomTree Dreyfus Emerging Asia Currency Fund

WisdomTree Dreyfus Emerging Europe Currency Fund

WisdomTree Dreyfus Emerging Latin America Currency Fund

WisdomTree Dreyfus Gulf Currency Fund

WisdomTree Dreyfus Oil Exporters Currency Fund 

In his overview, Mr. Lavine made it clear that WisdomTree sees currency ETFs as a way of providing American investors with a global emphasis in managing their cash exposure. His firm works closely with advisors and other institutional investors, and the feedback they were giving WisdomTree was for a cash vehicle that would make it simple to access better opportunities for their balances around the world. In short, their cash reserves were languishing in U.S. short term instruments that paid little interest. 

I asked whom he sees as being the primary buyers of currency ETFs, and he replied that ETFs are used by businesses that have the traditional hedging and foreign cash needs. But among sophisticated investors, currency ETFs are seen in some situations as preferable to equities as a way to play the growth of some countries. 

Mr. Lavine: “China, for example, has had its currency rise over the last six months, while the Chinese equity markets have fallen.”

He went on to add that this was just one example, and that currencies are seen by many as a legitimate asset class that deserves to be in portfolios on it own merits. Not only can currency ETFs increase in value and provide interest income, they also add stability to a portfolio because of their low correlation with traditional asset classes.

Overall, Mr. Lavine stressed that investors can look at cash holdings from an international perspective. There are times when it is better not to be in dollars; the recent market meltdown over Lehman Brothers and Bear Sterns is a good example. He referenced people in Europe who might buy a house priced in Euros and hold a mortgage denominated in Swiss francs. They have a different attitude toward holding foreign currencies--the implication being that Americans may also come to look at currency investing with the same international outlook.

Clearly, he expects currency investing to be a major asset class in the years ahead, and he is preparing his firm to be ready for it.

I then asked if WisdomTree would be doing much with bundled currencies. He answered, “Yes.”  

Looking at the last seven ETFs in the list above, one sees the importance they assign to this category of currency products. The BRIC currencies (Brazil, Russia, India and China) will be bundled. Emerging market currencies in Asia, Latin America and Europe will each be a separate ETF basket. And, the Developed Currency Fund (G10 + Singapore) is a slight deviation from the usual G10 grouping. The Gulf Currency Fund contains up to ten unspecified Middle East emerging markets currencies, and the Oil Exporters Currency Fund will consist of up to 10 currencies from oil exporting nations in North America, South America, Europe, and the Middle East.  All of these funds can vary their constituent members, but they are expected to keep fairly constant during the year, with quarterly rebalancing to equal weights. So, yes, they are going to be a strong player in the bundling segment of currency investing.

This led to my next question: “Are you considering any leveraged funds such as PowerShares (UUP) or a carry trade type of fund?” He said WisdomTree has a currency product team that will evaluate these kinds of options. For now, of course, they have their hands full working with the 25 funds they have in registration, although not all will necessarily make it this year.

We also discussed the technical structure of WisdomTree ETFs. As mentioned at the beginning of this article, Mr. Lavine was adamant that the active structure they chose for their funds would allow them to achieve a higher expected interest return than those from a grantor trust arrangement, such as Rydex uses for their exchange traded products. Rydex may use only overnight bank rates for their interest earnings, because of their charter as a grantor trust. But the WisdomTree ETFs, being actively managed, have some leeway in this decision. The active part of their single country funds is found in the choices of durations of their deposits.  In all the emerging markets, they use forward contracts and currency swaps as the basic asset. By extending the duration by only a month over the typical overnight bank rate, they can earn a higher return. According to Mr. Lavine:

“This potentially allows us to add from 30 to 35 basis points to the yield we get from our holdings.” 

I had to concede that their single currency products are actually actively managed, in this respect, and the flexibility it gave them was more than I had anticipated. 

Since currency swaps and forward contracts are used for all the emerging markets, this brought up the subject of counterparty risks. So, I asked him to identify the counterparties WisdomTree uses. “Citi (C), Goldman Sachs (GS), JP Morgan (JPM),” he replied. He went on to mention that by using multiple counterparties, the risks of a single counterparty failure are lessened.  

I then asked why WisdomTree included currency swaps in the asset mix in addition to forward contracts; he explained that there isn't much difference between these two instruments. They use forward contracts when dealing with a single currency. When there are a number of currencies, it is easier to use a currency swap that includes all the currencies in the same contract. He also mentioned the important role played in their currency transactions by Dreyfus.  Their extensive experience in international financial instruments is an important advantage in handling swaps and forward contracts.

While we were on the subject of interest earnings, it was time to indulge one of my pet peeves with their currency products.

Question: “I don't mean to be critical, but I am going to complain.  Why you don't pay monthly dividends on your currency products?” 

Mr. Lavine: “That's a fair question.  We use forward contracts and swaps on all the emerging market currencies.  So there is no guarantee that the cash will be available on a consistent monthly basis.  This could force us to sell part of the principle to meet a monthly dividend schedule.” 

He went on to describe how there can be short periods of falling interest rates where there would be little or no roll to be paid for a particular month. This uncertainty makes it too cumbersome to commit to monthly payments. They have no problem with the euro or yen, since they hold these currencies directly. The rolls on these currencies are settled quarterly, so they pay dividends on that basis.

The subject of ETF versus ETN did not come up directly, but his response to a comparison between the success WisdomTree has had with its Chinese yuan ETF (CYB), over a similar ETN offered by Van Eck (CNY), was informative. When I suggested that Van Eck's slow start might be attributable to their using the official name, Renminbi, rather than the traditional name, yuan, he was quick to say: “It's not because of that.  It's because it is an ETN.” He went on to point out ETNs lack transparency--the investor doesn't know what is being held in the fund. With an ETF, investors can look up the exact holdings every day. You know what you own with an ETF. Plus, an ETN investor holds a note payable, and the note's value is ultimately based on the credit worthiness of the issuer. No matter how high their credit standing is at the time of purchase, you have no idea what it will be down the road. Look at Bear Stearns and Lehman Brothers. Both highly respected and credit worthy one day--bankrupt the next. Mr. Lavine doesn't like the ETN structure and believes that investors don't either.

My last question was whether we could reasonably expect any of the funds currently in registration to be on the market before 2009. He responded that, yes, it was possible.

At the end of the conversation, Mr. Lavine asked if I was interested in ETFs that were not currency related. I said I was, and had reviewed their entire ETF lineup on their website before our conversation. He then volunteered that they will soon have a new ETF that covers the EAFE index (European, Australasian and Far Eastern markets), using their dividend approach for weighting. They already have an ETF that tracks a dividend weighted EAFE (DEFA), but their institutional clients, anticipating a rising dollar, wanted a product that would have developed markets exposure, but with protection from the currency risk. WisdomTree's answer is to bring out a new ETF which tracks the same market but that will be currency hedged! This new product will be available soon.

I don't know that WisdomTree will be successful in their quest for domination in the currency ETF market, if that is what they want. But I do know that they are 100% serious about taking it to the opposition--it's part of their strategy, and they brought Mr. Lavine in to press the action. For those interested in currency investing, it is only going to get better. With the aggressive agenda outlined by Mr. Lavine, there is a strong case to be made that currency investing is going to become a more recognized asset class to investors, and there are going to be a host of products that will encourage its growth. I think it is going to be an interesting couple of years ahead, as the top three or four firms battle it out in this exciting new market.

Comments

[Brian Shriver:]

Ray:

Again thanks for this great stuff.

I want to re-iterate a point I think I made in a comment on an earlier post (hoping Mr. Lavine will read this) that these products would be improved by increasing the duration of the debt purchased, at least for countries with higher interest rates. Not only would you get a higher local interest rate, but also you would improve the stability of the asset values in view of interest rate changes.

How does this work? Forex rates are pushed up by investment inflows and down by outflows. While forex markets are noisy, it is reasonable to assume that if the local R falls, investment will tend to shift outward, putting downward pressure on the currency. Meanwhile, however, the local bond has appreciated in value in local currency terms - but only in proportion to the duration of the bond.

The two effects offset each other. Conversely, currency ETFs with minimal duration in countries with high interest rates are more vulnerable to interest rate adjustments.

What's the general rule? When interest rates are high, it pays to invest in longer durations. When interest rates are low, it pays to invest in shorter durations. Good advice in any market. In this way you can benefit from long-term reversion to the mean.

Personally, I am already a fan of several of these products, but I would be more interested in investing in high-R currency products if the duration was longer.

Regards,
Brian

2008 Sep 24 11:42 AM

[Ray Hendon:]

Thanks for your comments, Brian. You do have a good point about the potential relationship between hot money and its effects on currency prices, but I am not signing on to the scenario you outline about inflows and interest rates. I think there are some flaws in the plan, but I'm not going to make a counter-argument now. It would take a lot of space and time, but this is something we might revisit at another time.

I will make one note, however. I think the most important variable in predicting the interest rate effect is not the relative rate of interest, i.e., high or low, but the direction of expected change. If interest rates are expected to rise and do, this would devastate longer-term bond prices, regardless of where they start from. It would, of course, help bond prices if they were expected to fall and did, in fact. fall.

Also, emerging markets do not support a sufficiently liquid high-quality credit market, so all of the ETFs that specialize in this segment of the market use forward contracts as their primary assets, and they depend on the roll for their interest earnings. You can only extend this out so far, and contracting with an exceptionally long roll period places a huge burden on the fund's net asset value. What if thery're wrong? I don't know of any that want to take on this type of risk.

You might consider contacting your local WisdomTree rep with your suggestion about venturing out the yield curve. From what I have learned from Mr. Lavine and from his counterpart at Barclays, they listen to their advisors clients. You might start a revolution in the business. (:~)

Thanks again for your input.

Best wishes,
Ray

2008 Sep 24 01:28 PM

[Obama is Bu...:]

Thanks for another really good article... I always learn something when I read your blogs

2008 Sep 24 04:01 PM

[Indexor:]

Excellent article. Another question that I was hoping to see answered: "What are the tax ramifications?" If I understand this aspect correctly, the IRS does not recognize currencies, or ETFs holding currencies, as an investment. Therefore, capital gain rates do not apply and all gains are taxed at the tax payer's higher ordinary income rate. Can you, or anyone, verify or correct this understanding?

2008 Sep 25 02:26 PM

[Ray Hendon:]

I discussed the tax issue with Mr. Lavine, and he provided me with an answer that I can't recall with enough specificity to do you any good. I am going to submit your question to WisdomTree for their official response. As soon as I get it, I'll post it here.

Thanks for the comments and question.

Ray

2008 Sep 25 03:02 PM

[Indexor:]

Thank you Ray.

2008 Sep 25 04:21 PM

[granger:]

Great info, thank you. I am a huge fan of their ETF's. Currently hold DPN.

2008 Sep 25 10:47 PM

[Ray Hendon:]

Indexor: Here is the official reply from WisdomTree:

Income distributions by the Funds, including distributions of short-term capital gains, will be taxed as ordinary income. Capital gain distributions by the Funds, if any, will be taxed as long-term capital gains. Gains from sales of fund shares will generally be taxed as capital gains in accordance with the investor's holding period. Shareholders should refer to the applicable WisdomTree Dreyfus Currency Income ETF prospectus for important tax information and should consult their tax advisers regarding their personal tax situation.

Hope this helps.

Ray

2008 Sep 26 02:04 PM

[Indexor:]

Thank you Ray. I greatly appreciate your efforts in re-posting this info.

2008 Sep 29 12:25 AM

[John the CFA:]

I'm now considering currency products. However, I still don't understand some of the dynamics of what Wisdom Tree is offering. Specifically, I'm not sure I understand the underlying structure of their products, and if they really give clients the optimal exposure and all of the appropriate benefits to the underlying currency (currencies). For example, I believe interest accrues daily in these funds, assuming they hold the currency directly, and (I believe) they also realize interest income from the collateral on the swap (or other holdings). I do not understand the portfolio construction methodology that would not permit this, despite the assertion by company officials. This also leads to a question on taxation - as a holder, will I suffer a tax consequence on income that the fund realizes (and keeps)?

It seems to beg the question as to whether or not Wisdom Tree is truly a foreign currency specialist. I mean, I thought they were an equity house giving investors a better alternative to such index shops as Vanguard? Is this, therefore, truly the right service for those needing exposure to currency? Help!

2008 Oct 03 02:41 PM

[Ray Hendon:]

John: I'm not sure I can provide you with the answer you need, but here's the way I understand their structure. First, only a few of their currency ETFs hold the actual currency. In all emerging markets they buy non-deliverable forward contracts or currency swaps if multiple currencies are involved. In both cases, an interest rate is built in to the contract, which is part of the forward market mechanism.

For the currencies they own directly (Euro or yen, e.g.) they use the currency holdings to invest in local short-term, high quality financial instruments, that on maturity, pay interest.

They may collateralize their forward contracts with U.S. Treasury obligations, and will earn interest on the holdings in addition to that paid on the forward contracts.

It is my understanding that all interest earnings are retained for the shareholders and are added to the net asset value as they accrue. This provision, I believe, is part of the requirements of the Investment Company Act of 1940 which regulates mutual funds and most ETFs.

Best, wishes,

Ray

2008 Oct 05 03:12 PM