Deutsche Bank Currency Pairs Fund Launched

September 19, 2006

New PowerShares Deutesche Bank G10 Currency Harvest ETF (DBV) uses currency pairs strategy to attempt to obtain outsized income.

The PowerShares Deutsche Bank G10 Currency Harvest ETF (DBV) has begin trading on the American Stock Exchange. While there are a number of currency products from Rydex already successfully trading on the market, this fund is a totally different animal.  Rather than passive exposure to certain currencies, the fund will use one of the oldest tricks in the FX trader's playbook in an attempt to generate strong returns.

The methodology is complicated, but here's the gist: The fund will use currency futures to make "paired trades" on major global currencies, matching long positions in currencies with the highest interest rates against short positions in currencies with the lowest interest rates.  History shows that there is a direct link between interest rates and currency appreciation, and this ETF is designed to capture it.

Using backtested data from 1993, the strategy has worked … beautifully … generating compound annual returns of 12.3 percent. That's good enough to beat the S&P 500 by nearly 2 percent over the time frame, and … here's the kicker … with half the volatility. Consider this: over the 13-year period of the backtest - a time that spanned the Asian currency crisis, the Internet bubble and September 11th -- the strategy posted negative results just once, in 1998, when it lost 1.7 percent.

I'm not usually one to be tempted by backtests, but this one sure looks pretty.

An Alternative Asset Leader

Deutsche Bank has quickly made a name for itself in U.S. exchange-traded fund (ETF) industry with their breakthrough Deutsche Bank Commodities ETF (ticker: DBC).  DBC is the first … and so far the only … broad-based commodities ETF in the U.S.  Launched in March, the fund has already attracted over $600 million in assets.

 

But Deutsche Bank doesn't want to be a one-trick pony.  They plan to expand into one of the leading players in alternative asset ETFs in America. The new Currency Harvest is the first step in that process, and it's a doozy.

Rather than tracking a single currency, like the Rydex products the Deutsche Bank product will use leveraged long and short positions in different currency futures with the goal of capturing positive absolute returns.  The fund begain trading on September 18th  on the American Stock Exchange (Amex) under the ticker symbol "DBV." 

 

Interest Rates Make The Difference

 

The new fund will track the performance of something called the Deutsche Bank G10 Currency Future Harvest Index.  The index is designed to take advantage of a simple and long-noticed trend in the currency markets: namely, that currencies with high interest rates tend to rise in value compared to currencies with low interest rates.

 

To capture this trend, the fund will take long positions in the three G10 currencies with the highest interest rates, and short positions in the three currencies with the lowest interest rates.  The fund will have 2X leverage to the long side, meaning that it will invest twice as much money in the long currencies as it does in the short currencies.

 

The ten currencies are:

U.S. Dollar
Euro
Japanese Yen
Canadian Dollar
Swiss Franc
British Pound
Australian Dollar
New Zealand Dollar
Norwegian Krone
Swedish Krona

 

The only quirk is that the fund will not invest in the U.S. dollar, even if the dollar is among the highest- or lowest-yielding currencies. Deutsche Bank figures that since investors will buy the fund with dollars, they will already be exposed to that currency.  If the dollar happens to be among the highest-or lowest-yielding currencies, the fund will simply not invest that portion of its portfolio until the next rebalance.  In other words, if the dollar is among the three lowest-yielding currencies, the fund will only be 67 percent short, instead of 100 percent short.

The index - and the fund - will be re-weighted on a quarterly basis.

 

Like most futures-based funds, DBV will only have to put up a portion of its money to buy the necessary futures contracts. The leftover collateral will be invested in 3-Month Treasuries, which will create interest rate income for the fund.

 

Deutsche Bank expects total expenses for the fund to be 0.96 percent in the first year. At the same time, the fund is expected to generate 4.77 percent in annual interest income, meaning the fund should rise 3.81 percent per year before the gains/losses from trading.

 

Performance?

 

And how, you ask, has the fund performed?  That's the amazing thing: Based on historical data, this strategy has performed extraordinarily well.

 

From 1993 - 2005, the "total return" version of the Deutsche Bank G10 Currency Future Harvest Index has delivered compound annual return for the index was 12.3 percent.  The "total return" index takes into account the collateral return on Treasuries investments.

 

Over the same time period, bonds have returned 6.2 percent, while the S&P 500 has returned 10.5%.  Only commodities, as measured by the Deutsche Bank Commodities Index, have done better (13.7 percent).

That's pretty good, but here's the kicker: the Currency Index has posted 12.3 percent compounding annual returns with very little risk.

 

DEUTSCHE BANK G10 CURRENCY FUTURE HARVEST INDEX™-TOTAL RETURN
CLOSING LEVELS TABLE

 

  

High1


 

  

Low2


 

  

Annual
Performance3


 

 

 

Performance
Since Inception


 

 

19934

  

106.15

  

95.13

  

2.30

%

 

2.30

%

1994

  

116.32

  

102.32

  

12.15

%

 

14.73

%

1995

  

124.55

  

102.55

  

8.56

%

 

24.55

%

1996

  

166.84

  

125.01

  

33.95

%

 

66.84

%

1997

  

180.54

  

164.92

  

8.01

%

 

80.19

%

1998

  

195.70

  

172.90

  

-1.68

%

 

77.17

%

1999

  

203.96

  

177.49

  

15.12

%

 

103.96

%

2000

  

227.93

  

202.75

  

11.11

%

 

126.61

%

2001

  

259.57

  

226.67

  

14.55

%

 

159.57

%

2002

  

307.46

  

261.27

  

17.68

%

 

205.47

%

2003

  

365.18

  

306.83

  

19.55

%

 

265.18

%

2004

  

398.14

  

359.55

  

8.16

%

 

294.97

%

2005

  

465.01

  

392.58

  

14.23

%

 

351.19

%

20065

  

458.13

  

444.08

  

1.37

%

 

357.39

 

 

Asset

Annualized Returns

3-Month Daily Volatility

Sharpe Ratio

Currency Harvest Index

12.3%

7%

1.27

U.S. Treasuries**

6.2%

4.6%

0.61

S&P 500

10.5%

15.4%

0.46

Deutsche Bank Commodities Index

13.7%

19.1%

0.54

** EFFAS US Treasuries" is Bloomberg/EFFAS Index of U.S. Treasuries.

 

The performance reminds me of the CBOE BuyWrite Index, which posts better long-term returns than the S&P 500 as well.  Except the risk/reward ratio for the Currency Harvest index is even better, and volatility is lower (9.4 percent for the BuyWrite Index, compared to 7 percent for the Currency Harvest).  Just look at the strong and steady returns shown in the chart below -- the steady black like is the Currency Harvest index.

In addition, the index has had a historically weak correlation with traditional asset classes, including a negative correlation with U.S. Treasuries and only an 18 percent correlation with the S&P 500.

The fund will be taxed as all futures-based investments are taxed, with any capital gains or dividend income taxed as 60 percent long-term gains and 40 percent short-term gains.

 

Conclusion

With a weak or negative correlation to traditional asset classes, and strong, steady returns, it is hard not to get excited about a product like the DBV.  The fund, however, faced two enormous challenges.

 

The first - the SEC - has already been tackled.  The SEC has now approved an ETF that uses short positions (ProShares) and currencies - all this year.

 

The other significant challenge DB faces will be educating investors and financial advisors about currencies and currencies strategies.  The CBOE's BuyWrite strategy has only recently caught on with most investors, despite using an investment style favored approach by institutional investors for years.  People may find the Currency Harvest Index simply too unusual to include in their portfolios.

But it could pay to take a close look at it.

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