CYB: What Ails the Yuan ETF?

| About: WisdomTree Chinese (CYB)

The WisdomTree Dreyfus Chinese Yuan Fund ETF (NYSEARCA:CYB) is a currency ETF that uses non-deliverable forward contracts to allow foreign investors to benefit from the gradual appreciation of the yuan. According to the company:

WisdomTree Dreyfus Chinese Yuan Fund seeks to achieve total returns reflective of both money market rates in China available to foreign investors and changes in value of the Chinese Yuan relative to the U.S. dollar. Although this fund invests in very short-term, investment grade instruments, the fund is not a money market fund and it is not the objective of the fund to maintain a constant share price.

The fund charges an expense ratio of 0.45%.

[Click to enlarge]

Many investors are surprised to see the divergence between the performance of CYB and the yuan spot price as shown in the chart above. CYB buys near-month (one-to-three month) non-deliverable currency forward contracts relating the yuan to the dollar, and rolls these forward constantly.

Those currency forward contracts fluctuate based on market expectations of the future price of the yuan. In effect, the CYB is like any other forwards- or futures-based ETF. All such ETFs suffer from these divergences from the spot price, since the forwards / futures market reflect anticipated spot prices one to three months out. This is similar to the contango effect for commodity futures-based ETFs.

Actually, the difference between forwards and futures is mostly based on the fact that the former are OTC contracts between two parties, while the latter are exchange-traded. If and when the yuan floats freely and becomes exchange-traded, yuan futures-based ETFs will emerge; until then, we are stuck with non-deliverable forward contracts.

So don't buy the CYB expecting it to track the spot price like a one-month CD might. Over the last year, the yuan has appreciated more than 4% versus the dollar, while CYB has been flat. CYB invests the collateral (backing the forwards) in U.S. treasury bills; T-bills are short-term fixed-income instruments ranging from weeks to a few months. CYB could generate annual distributions in the form of ordinary income, short-term capital gains, or long-term capital gains.

If you want to park some long-term money in a fixed-income product that gives you exposure to the appreciation of the Chinese yuan, CYB is a good choice. But don't park your short-term money in this ETF; as the chart above shows, it can lose money in the short-term.

Bank of China (OTCPK:BACHY) recently introduced yuan currency accounts for U.S. residents living in New York and a couple of other cities. The limit is $25K per year. Everbank also has yuan deposit CDs. These are alternatives to forwards-based ETFs such as CYB. There is also a forwards-based ETN, CNY, that I am not discussing since CYB is a better choice. ETFs are safer than ETNs since the latter are subject to credit risk of the issuer; so, all else being equal, always pick an ETF over an ETN.

So will CYB forever underperform the spot price? Not necessarily. If the Chinese government surprises the market by suddenly revaluing the yuan upwards (overnight), CYB will spike, since the market will start building in expectations for faster yuan appreciation in the months ahead. CYB’s performance therefore depends on how well the actions of the Chinese government match the market’s expectations for the yuan’s appreciation in the months ahead.

Nobody can predict what the Chinese government will do and when. All we can say is that the yuan is destined to appreciate over the long term. So for patient long-term investors who want a pure-play exposure to the Chinese currency, CYB is a decent choice. Such investors shouldn’t be too concerned about monthly gyrations in market expectations for the yuan. I just want to caution such investors to be prepared for short-term underperformance with respect to the spot price.

Disclosure: I am long CYB.

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