One of the casualties of the world financial crash of 2008 was the carry trade. For the investor to make money on the interest rate differential between two currencies, it is imperative that the currency prices remain stable. Many of the emerging market currencies fell almost 50% from the last quarter of last year. This forced carry traders to liquidate their currency exposures. The carry trade went into a tailspin, and since then it’s been a waiting game for stability to return to world trade and to currency prices.
The picture has changed over the last few months, however, as the graphs below show. The first chart shows prices of the Mexican peso ETF of Rydex Investments (FXM) over the last year. The prices are the dollar value of 1000 pesos. From its peak in August of last year, the peso fell over 35% to its low in early March of this year, at which time it began something of a comeback.
Mexican Peso/Dollar 1-Year Prices
Almost all of the emerging market currencies have made similar recoveries from their lows, and they continue to improve as the world’s economies head to recovery--we hope!
Even the developed currencies like the Euro and pound sterling have taken their licks. The pound fell about 30% over the same period.
£/Dollar (FXB) 1-Year
There is another casualty of the financial carnage of last year. Prior to August of last year, ETF and ETN providers were flooding the SEC with proposals for foreign currency exchange traded products. I was running out of disk space trying to keep up with all the new filings. The collapse of the currency markets brought all these plans to a virtual standstill, and there were no new offerings for the rest of 2008.
Now, however, things have changed enough for one of the providers, WisdomTree, to follow through with their plans. On Wednesday, May 6, they brought the WisdomTree Dreyfus Emerging Currency Income Fund (CEW) to market.
This new EM bundle includes 11 currencies, ranged around the world from Central Europe, Africa, Latin America and Asia. WisdomTree chose to put their new ETF under the Investment Act of 1940. This means, among other things, investors will have daily transparency of holdings and prices for their new product.
Initial sales look robust, with an average daily volume over 100,000 shares. It carries an estimated interest yield of about 4.6%.
This is a most interesting product. The inclusion of 11 currencies provides a degree of diversification not provided by single-currency ETFs. The list includes: Turkish lira, Brazilian real, South African rand, Polish zloty, South Korean won, Chilean Peso, Mexican peso, Israel shekel, Indian rupee, Taiwanese dollar, and the Chinese yuan.
I like the geographic diversity: it covers all the continents except Australia. I also like the equal weighting scheme they use to determine how much of each currency to hold. The fund will be rebalanced quarterly, and WisdomTree will remove a currency if, in their assessment, the political or economic environment becomes hostile to an orderly currency market.
This new ETF is similar to an older currency product, the Global Emerging Markets Strategy ETN, (JEM). I covered this ETN when it was first introduced in my June 26, 2008, article, Currency Bundles Pegged to the Dollar. JEM has fifteen currencies represented in their bundle. Ten of the currencies are the same as CEW, but JEM includes Russia rather than China, and it includes currencies in five countries not covered by the WisdomTree product: Columbian peso, Philippine Islands peso, Argentine peso, the Indonesia rupiah, and the Hungarian forint.
The recent price history of JEM is shown below. The share price fell from about $51 in July to its low of about $38 in February of this year, a 25% fall.
JEM was introduced at a decidedly unfortunate time, with political and financial instability just beginning in some of its target currencies. The results show in the relatively few assets this ETN has gathered since its inception (Bloomberg lists $2.98 million in assets in their latest data).
Yields on this bundle have been quite good, however, with the last dividend yielding about 9% annualized, but this return has been swamped by falling prices of some of the more unstable currencies.
I prefer the bundle offered by CEW, because some of the more volatile currencies have been omitted. For example, it does not have Russia, Hungary, Argentina, or the Philippines in its mix. Plus, the inclusion of China, which follows a relatively tight peg to the dollar, will help stabilize price fluctuations.
I also prefer the ETF form to the ETN. With last year’s carnage of supposedly unsinkable financial giants, I wonder if the ETN has much of a future.
WisdomTree’s website goes into detail about the expected interest earnings and the standard deviation of the returns of each country.
Although listed as an “income” fund, it will not behave like a normal income fund that is denominated in U.S. dollars. The dividend comes from interest earnings on short term cash instruments in each of the markets they include in their basket. Currency price fluctuations can eat up the interest earnings in a hurry.
Investors must also be aware that by including 11 countries in the mix does not necessarily completely diversify the risks of systemic failure. Emerging Market currencies are prone to move in the same direction during major disturbances, as they recently proved, so the normal safety in numbers is trumped by the herding instincts of investors.
WisdomTree properly recommends keeping currency investing to a 10% maximum of your total portfolio’s value. Part of their case for holding currencies is to moderate the downside risks of portfolios dominated by equities and fixed income holdings. Currencies are remarkably uncorrelated with equity and bond prices, so there is an advantage of lowering total portfolio volatility when currencies are included in the mix. In this case, adding a volatile currency may actually lower overall portfolio volatility because of the counter-cyclical properties of currency holdings.
Depending on your own preferences for risks, and whether you want to hedge your emerging markets equities against possible dollar depreciation, this new ETF may provide your portfolio with some important benefits. I welcome this new offering as a potential tool in balancing the risks when taking on emerging market equity investments. I hope that as the market recovers, some of the other filings of 2008 will see the light of day. Currency investing is not for everyone, but for those who can use it, a wider set of options is welcome.
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