Emerging Markets: Investment Opportunities In Currency Arbitrage

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About: WisdomTree Emerging Currency ETF (CEW), Includes: EWZ, RSX
by: Andrii Taranukha
Summary

Currency risk in emerging markets is one of the major factors that affects investors’ wealth.

For the last year, Brazilian and Russian equity had an outstanding performance due to currency appreciation.

The latest election in the USA brought uncertainty to the trade policies, which resulted in emerging market currency depreciation.

Investment in actively managed ETFs provides unique investment and diversification opportunities.

Emerging markets provide investors with unique investment opportunities; they allow them to not only achieve higher returns through greater exposure but also to diversify a portfolio.

Investors can choose between asset classes such as equity, fixed income, and currency. For equity and fixed income securities, currency volatility represents additional risk; while appreciation improves performance, depreciation destroys shareholder wealth.

As an example, I will consider the largest Brazilian and Russian single country ETF: iShares MSCI Brazil Capped ETF (NYSEARCA:EWZ) and Market Vector Russia Trust ETF (NYSEARCA:RSX), respectively, as those markets had an outstanding performance compared to the rest of the emerging market single countries ETF.

Since 2014, both countries have been affected by the decline in the price of commodities, combined with political risk resulting in the depreciation of their national currencies.

Source: Bloomberg Terminal

Source: Bloomberg Terminal

Improved monetary and fiscal policy and usage of the reserves has allowed the governments of the emerging markets to support the strength of the local currencies.

As a result, the real and ruble have appreciated, which translated into better performance in USD relative to the return in local currency.

Source: Bloomberg Terminal

Source: Bloomberg Terminal

Is there any way to take exposure only on currency?

For investors who don't want to bear the additional company-specific risk, there is an excellent opportunity to invest in the currency ETF: WisdomTree Emerging Currency Strategy Fund (NYSEARCA:CEW).

Volatility is the only one smiling today.

The result of the USA election was an unpleasant surprise for the emerging markets, as it increased volatility in the emerging market countries. While some investors may believe that volatility is adverse and only leads to loss, others view it as having an upside potential.

Source: Bloomberg Terminal

Source: Bloomberg Terminal

Before the elections, the WisdomTree Emerging Currency Strategy Fund had a high performance and outperformed the S&P 500 Index (SPX).

Source: Bloomberg Terminal

The election results increased the uncertainty and boosted the withdrawals from emerging markets, which led to the depreciation of the local currencies. As a result, the fund started to underperform.

Source: Bloomberg Terminal

How can one take exposure on the volatility and benefit investment in the WisdomTree Emerging Currency Strategy Fund?

  • The fund invests into short-term non-deliverable currency forwards, where one party agrees to buy a currency from another at a pre-determined price at some point in the future. The fund focuses on arbitrage opportunity on the difference between forward rate and spot rate, which is settled in cash.
  • The depreciation of the emerging market currencies decreased NAV and compared to the other emerging market funds, the WisdomTree Emerging Currency Strategy Fund experienced cash inflows after the election, meaning that investors have a positive outlook on the currencies.

Source: Bloomberg Terminal

  • The share's trade is below the 50- and 200 - day average, which creates an opportunity to buy shares cheap.

Source: Bloomberg Terminal

  • Uncertainty over Donald Trump's protectionist policy is the primary driver behind the currency depreciation of the countries that depend on exports. Nevertheless, considering Trump's decision over NAFTA and the TPP agreement, currency exchange rates will stabilize and adjust to Trump's new policies even if they are implemented.
  • Emerging markets have a higher deposit rate on the currency comparing to developed markets. This provides an opportunity to have a cheap cost of borrowing and invest in a short-term investment grade instrument with a higher yield.

Source: Bloomberg Terminal

  • The markets are expecting that the increase of 0.25% in interest rates will slightly increase the borrowing cost and strengthen the dollar. Still, the emerging markets offer higher yields and in the long run, markets will adjust to the new interest rate.
  • Based on the Big Mac Index, most of the emerging market currencies are undervalued.

Source: Bloomberg Terminal

  • Based on the forecast of the total returns, for the first quarter of 2017, the Brazilian real, Indian rupee, Philippine peso, Polish zloty, Russian ruble and Turkish lira are all forecasted to appreciate. The mentioned currencies consist 40.02% of the WisdomTree Emerging Currency Strategy Fund holdings that may lead to the high upside potential.

Source: Bloomberg Terminal

  • The fund doesn't have a benchmark and is actively managed, which allows freedom of rebalancing to explore market inefficiencies.
  • The fund is well diversified, and if the correlation is below one based on the correlation matrix (i.e. perfect correlation), the overall portfolio risk decreases.

Source: Bloomberg Terminal

  • The addition of the WisdomTree Emerging Currency Strategy Fund into the portfolio is a good way to diversify developed market ETFs.

Source: Bloomberg Terminal

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.