3 Innovative Currency ETFs

04/21/2011 7:00 am EST

Focus: ETFS

Michael Johnston

Co-Founder and Senior Analyst, ETF Database

Discover three exchange traded funds that offer currency market exposure beyond the traditional means. Buyers can tap into fast growing commodity or Asian currencies or even simulate the popular carry trade.

ETFs have become popular in recent years as tools for establishing low-cost and tax-efficient exposure to traditional asset classes such as stocks and bonds. But the exchange traded structure also carries appeal as a means of accessing asset classes that have historically be hard to reach or difficult to efficiently maintain.

That is certainly the case in the commodity space, as investors have embraced a comprehensive lineup of exchange traded commodity products as a way to bet on prices of natural resource like gold and oil.

Many have also turned to ETFs for currency exposure, whether it be hedging against exposure maintained elsewhere in a portfolio or speculating on movements in exchange rates. There are currently 30 ETFs in the ETFdb currency category with aggregate assets in excess of $5.5 billion.

The majority of those products offer exposure to the value of a single foreign currency relative to the US dollar, including the Chinese yuan, Swedish krona, and Russian ruble. But there are a handful of products that offer a different type of currency exposure, highlighting the numerous potential uses for this application.

Below, we profile three of the more interesting exchange traded currency products and how they might fit into a portfolio or trading account. Keep in mind that ETFs differ from ETNs in several ways. (Read more about the difference between ETFs and ETNs here.)

WisdomTree Dreyfus Commodity Currency Fund (CCX)

This ETF is designed to offer exposure to money market returns available in certain commodity-producing countries, as well as the performance of these currencies relative to the US dollar.

CCX democratizes a strategy that has long been popular on institutional trading desks, focusing on currencies of resource-rich countries that are generally significant producers and exporters of commodities.

The current list of currencies includes both emerging and developed markets: The Australian dollar, Brazilian real, Canadian dollar, Chilean peso, Norwegian krone, New Zealand dollar, Russian ruble, and South African rand.

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Represented in that group are the world’s largest exporters of gold, silver, nickel, natural gas, sugar, zinc, coal, iron ore, aluminum, and livestock, as well as major producers of other natural resources.

Instead of thinking of CCX as a basket of exchange rate fluctuations, it is helpful to understand the factors that have historically impacted the value of commodity-intensive currencies. These currencies tend to fluctuate based on the health of the global economy; during booms, demand for raw material surges, which can translate into increased demand for the related currency.

CCX can also be used as a tool to hedge against inflation—particularly unexpected upticks in US inflation, a phenomenon that often leads to a decline in the greenback relative to currencies linked to major sources of raw materials.

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Barclays GEMS Asia-8 ETN (AYT)

AYT is one of the rare exchange traded products whose name sheds little light on the investment objective. This exchange traded note is linked to an index that produces the return of long-only investing in one-month synthetic money market deposits in a basket of eight Asian currencies: The Indonesian rupiah, the Indian rupee, the Philippine peso, the South Korean won, the Thai baht, the Malaysian ringgit, the Taiwanese dollar, and the Chinese yuan.

For investors who see emerging Asian economies as the primary driver of global GDP growth going forward, AYT may be a nice way to round out exposure to the region. Most looking to bet on a prolonged Asian bull market gravitate towards equities, but AYT, along with the recently launched Asia Bond Fund (ALD) present opportunities for investing in Asia beyond the traditional methods.

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The basket of currencies that makes up AYT can help to smooth out volatility while offering exposure to currencies of economies that offer attractive yields on debt.

But there is certainly some risk in this approach as well. In the late 1990’s, many of the component currencies were battered after the Thai government cut the peg of the baht to the US dollar.

As a result, many Southeast Asian stock markets and currencies crumbled. A repeat of the ’97 Asian financial crisis seems like long shot in the current environment, but history teaches a powerful lesson on the connections between these economies.

iPath Optimized Currency Carry ETN (ICI)

The currency carry trade has been around for decades. This strategy involves borrowing in low-yielding currencies (in the current environment, the Japanese yen and US dollar) and establishing long positions in higher-yielding currencies.

In many environments, the carry trade can generate a nice return with relatively low volatility, allowing investors to exploit interest rate differentials across different markets.

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But the currency carry trade is far from arbitrage; there are several risks, and the last several years are full of examples of the adverse impact an unwinding trade can have on portfolios.

The rapid appreciation of the yen burned investors who had borrowed in the Japanese currency, as they suddenly found themselves forced to repay more expensive debt with a cheaper currency.

Because funding currencies tend to also be safe havens, periods of panic can wreak havoc on the carry trade ICI maintains a somewhat surprising allocation at present; the ETN has long exposure to both the yen and greenback, while the Canadian dollar and Swiss franc are the biggest short allocations.

By Michael Johnston of ETFdb.com

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