Carry Trades for the Masses

12/01/2009 9:32 am EST


Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Baskets of emerging market currencies deliver higher yields for those willing to part with their dollars, writes Carl Delfeld in Around the World with

The global carry trade refers to borrowing in US dollars at low interest rates and investing in higher-yielding currencies…Many believe that the trend of a lower US dollar is inevitable given our fiscal imbalances.

The most popular ways to play this idea is [through] a pair of funds that seek to replicate the carry trade—the PowerShares G10 Currency Harvest fund (NYSEArca: DBV), and the iPath Optimized Currency Carry Fund (NYSEArca: ICI). Both of them use futures to capture the local currency returns.

There are some differences between the two. DBV is a true ETF where shareholders own shares in a trust, while ICI is an exchange traded note (ETN), which is backed by Barclays. In addition, DBV goes long the three highest-yielding G10 currencies while going short the three lowest-yielding currencies.

The results can be highly volatile: In the second half of 2008, the fund fell over 30% as the yen (one of the shorts) rose and the Aussie and New Zealand dollars (the longs) fell. This is part of the problem, because some low-interest-rate currencies can actually do quite well for other [reasons]. This is especially true in times of global turmoil, when low-rate countries like the US and Japan gain huge flows due to their overall stability and low political risk.

ICI takes a bit of a more sophisticated and conservative approach, carefully selecting G10 currencies to invest in so as to maximize carry while minimizing volatility. It’s also cheaper than DBV, charging 65 basis points rather than 75 basis points per year. It’s a good vehicle provided you don’t mind [its] market capitalization of less than $30 million.

My favorite is the WisdomTree Dreyfus Emerging Currency Fund (NYSEArca: CEW), a basket of 11 emerging market countries’ [currencies]. The allocations as of early November were as follows: 36% China, South Korea, India, and Taiwan; 28% Brazil, Chile, and Mexico; 18% Israel and Turkey, and 9% each for Poland and South Africa.

The Federal Reserve continues to signal that rates will not be raised while the US and global economy appears fragile. This just encourages investors to borrow in dollars and search for higher-yielding options in countries such as emerging markets. The risk factor is high, and I suggest using CEW only in moderation and using a 6%-8%
trailing stop loss.

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