A Different Way To Play Emerging Markets?

May 20, 2009

Will the new WisdomTree currency ETF prove to be a less volatile and beneficial means to invest long term in developing markets?


Earlier this month, WisdomTree launched the first broad basket of emerging market currencies in the exchange-traded funds space. 

The story was widely covered. (See related article here.)  But it's important to note that while investors will be buying exposure to currency fluctuations, this new fund's fortunes will also be tied to what happens with short-term interest rates. 

Consider the makeup of the WisdomTree Dreyfus Emerging Market Currency Fund (NYSE Arca: CEW). It's designed to deliver currency exposure through trading forward contracts on short-term money market rates in selected emerging market countries. 

The fund has no index, is considered active and rebalances quarterly. However, CEW is likely to act more like an index representing emerging markets money market rates. Where no such index exists, this fund gives exposure to short-term emerging markets rates and currency exchanges, equal-weighting among countries. 

How It Works 

Before this fund, the only ETF coverage of emerging market fixed income did not include currency; something that CEW brings to the ETF market. 

There are two components that drive the return of this fund: income from money market rates, and foreign currency exchange to the U.S. dollar. The fund uses short-term, 90-day, forward contracts to synthetically deliver results similar to holding money market securities in the emerging market countries included in the fund.

Short-term price movements of the fund largely return the mark-to-market of the forward contracts, reflecting changes in currency movements. However, it is both the income and currency component, within the forward contracts, that may be equally important, that together give the total return of the fund.  

According to a press release from WisdomTree on May 6, 2009, Bruce Lavine, WisdomTree president and COO, said this about the new fund:

"Our new Emerging Market fund fills an important void in the ETF landscape by giving investors the first currency basket product delivered in the 1940 Act fund structure. CEW should be attractive to investors interested in diversifying outside the U.S. dollar or accessing a less correlated asset class."

Growth In Emerging Markets 

The 1940 Act Lavine refers to is the Investment Company Act of 1940, which was established to set up mutual funds. This is important when concerning exchange-traded products that are designed to give exposure to currency. Typically, currency products are exchange-traded notes, which are a form of debt issued by the issuing investment bank, and give investors the return of an index.

This also means that tax consequences from long-term gains of the fund will be taxed as capital gains. Distributions from this fund will be paid annually and come from these two factors, according the WisdomTree: income from the fund's investment in U.S. money market securities and foreign currency contracts.

The WisdomTree Dreyfus Emerging Market Currency Fund comes to the market as part of the currency lineup from WisdomTree. WisdomTree has been able to offer this unique exposure to currencies through its expertise in the use of forward contracts inside this kind of product.

The growth potential of emerging markets has been widely discussed and in recent years has driven global economic growth. Growth in these countries can be reflected in their relative currency strength.

Other emerging market bond ETFs invest in emerging market government debt issued in U.S. dollars. CEW can give investors direct currency exposure while removing the risk of taking on more duration, or sensitivity to interest rate movements, that other emerging market debt ETFs carry from longer maturity lengths. 



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