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Currency ETFs Do Matter

December 19, 2012
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Recently, my colleague and friend Paul Baiocchi declared currency ETFs irrelevant. Sorry Paul, but you’re dead wrong.

I do recognize that currency ETFs might not have experienced the massive growth that, say, fixed-income ETFs have in the past few years. After all, it’s not every day that you get a blockbuster like the PIMCO Total Return Bond Fund ETF (NYSEArca: BOND).

But, with QE-infinity underway, and central banks actively engaged in the devaluation of their currencies—I would argue that currency ETFs are more important now than ever.

For one, the $3.8 billion in assets that Paul quoted for currency ETFs conveniently excludes the heavily traded and utilized leverage and inverse currency ETFs. When you include those funds, the currency ETF space is really around $4.5 billion.

Granted, that’s nothing compared to the assets in fixed-income or equity ETFs, but it’s hardly irrelevant, Paul.

The fact is—the incorporation of currencies into a diversified portfolio is still fairly new to many investors.  For the longest time, the forex markets have been dominated by large institutions, banks, and traders aiming to hedge their exposure or speculate.

However, with the growth of ETFs in the international equity and fixed-income space, investors are more exposed now than ever to foreign currency fluctuations. This fact doesn’t make currencies moot—it makes it a reason to understand and manage exposure.

Take a look at the chart below—it’s the year-to-date performance of the MSCI Brazil Index in dollars and in the local Brazilian currency, the real. The dollar version of the index takes into account the exchange of Brazilian reais into U.S. dollar.

As a result, whenever the real depreciates, U.S. investors suffer; and whenever the real appreciates, U.S. investors get a boost.

In the past year, local investors in Brazil returned a bit more than 11 percent, while U.S. investors in Brazil were actually slightly in the red, with the difference centering entirely on the dollar having the upper hand in the currency cross.

MSCI_Brazil

 

For investors in funds like the iShares MSCI Brazil Index Fund (NYSEArca: EWZ), returns in the past year have taken a beating due to the depreciating real. And it’s hardly a surprise— the Brazilian central bank has favored a weakened real and a stronger U.S. dollar to increase exports.

For someone looking to buy Brazilian equities, the option to short something like the WisdomTree Dreyfus Brazilian Real ETF (NYSEArca: BZF) is incredibly valuable in such a market environment. Moreover, the fact that you can take a position in BZF without going through the hassle of setting up a forex trading account is massively convenient.

Although single-currency ETFs may not be blockbusters, they’re still very viable tactical vehicles. However, this doesn’t mean we should write off the basket strategies.

As Paul pointed out, the bulk of assets in the currency ETF space are in funds like the PowerShares DB US Dollar Index Bullish ETF (NYSEArca: UUP) and its counterpart the PowerShares DB US Dollar Index Bearish (NYSEArca: UDN). These funds have become increasing popular as the Fed has continued its quantitative easing program.

Giving investors access to basket strategies that allow them to diversify away from the dollar is likely where currency ETFs can still experience growth, and still there may be room for growth in single currency funds as investors discover how to tailor their exposure.  There’s no reason to write off an entire asset class based on a few closures.

 

At the time this article was written, the author held no positions in the securities mentioned. Contact Ugo Egbunike at uegbunike@indexuniverse.com.

 

 

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