The Irrelevance Of Currency ETFs

December 06, 2012

Two WisdomTree currency ETFs closed up shop this week, highlighting the lack of interest in the asset class.

The expansion of the ETF market has been well documented here and elsewhere, but off-the-beaten track asset classes have yet to really catch on.

Currency ETFs, for example, have fewer assets now, at $3.8 billion, than the $4.5 billion they had at the same time last year.

Just 24 currency ETFs are now on the market, with average assets of $160 million. And of those 24, not one has more than $1 billion in assets, and less than 10 of them have as much as $100 million.

In fact, once you add up the top 10 currency ETFs, less than $200 million is spread across the remaining 14 funds. Only one fund, the CurrencyShares Euro Trust (NYSEArca: FXE) gets more than $100 million in daily volume, and less than $200 million in volume comes into all currency ETFs combined on a daily basis.

In other words, realistically there are fewer than 15 viable currency ETFs on the market right now.

It may be that currencies fit poorly in an ETF wrapper. After all, currency markets are the most liquid on earth and are open 24 hours a day. For an ETF to be a reasonable replacement, it must trade with tight spreads and attract hundreds of millions in daily dollar volume.

Unfortunately, the number of ETFs that fit that bill right now is fewer than five.

What’s more, ETFs focused on foreign exchange markets are necessarily designed for the retail audience. The problem is, most individual investors don’t have any interest in speculating on currencies, and the availability of currency ETFs won’t change that.

It’s not a new problem, either. After all, investors have been able to open forex accounts for decades, and the retail adoption of those strategies has been spotty at best.

I mention that basic challenge without even considering the complexity of the actual mechanics of currency ETFs.

Some, like WisdomTree’s products, take both long and short exposure in currency forwards, while others buy local-currency-denominated sovereign bonds. In both cases, the exposure you get may differ greatly from the quoted exchange rate you will see on your favorite financial website.

As such, the products are most likely to be used by institutional investors or more sophisticated advisors managing client funds.

And the truth is that most of those institutions have access to cheaper forex exposure either via the bank where they custody funds or through relationships they have in the industry. Compared to the five-, 10- or 75-basis point bid/ask spreads on many currency ETFs, going directly to the forex market instead is a no brainer.

So why then are any currency ETFs attracting assets?



One reason may be the relative attractiveness of basket strategies.

The top currency ETF, the PowerShares DB US Dollar Index Bullish Fund (NYSEArca: UUP), offers exposure to the currencies that constitute the U.S. Dollar Index.

Clearly, using this type of ETF in place of managing the weightings to the yen, euro or loonie via the forex market may make sense for some large investors.

Another reason may be access. Markets like China and India, where currencies are restricted, are harder for even institutions to access. As such, the ETF wrapper may be investors’ only option for speculating on these currencies or for putting on a hedge.

Finally, there may also be investors looking to improve the yield of the cash position in their portfolio. With negative real yields here in the U.S., currencies like the Aussie dollar and Canadian loonie are increasingly attractive as parking lots for cash.

That helps explain why the CurrencyShares Australian Dollar Trust (NYSEArca: FXA) and the CurrencyShares Canadian Dollar Trust (NYSEArca: FXC)—two of the highest-yielding currency funds on the market—have a combined $1 billion in assets between them.

It remains to be seen if the currency ETF market will continue to consolidate to the point where a handful of strategies remain and issuers abandon the rest.

After all, most investors have no desire to strip out their currency exposure, and institutions can probably do better in most currencies by transacting in the forex market directly.

If the recent closures are any indication, the currency ETF market is not the place to look for growth moving forward.



At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at [email protected].

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