The Divergent Fortunes Of Currency ETFs

The recent challenging economic climate for some of the major economic regions has re-awoken the currency markets sparking the rise of the FX exchange traded fund. But, while the rise in volatility has caught investor interest in the asset class, only certain FX strategies are proving popular.

Accessing the FX market is not easy for smaller investors, the sophistication required to trade the FX spot, forward and future markets means that, previously, it has largely been confined to institutions. However, a number of ETF and index providers have been busy developing a range of different currency products to improve access.

In Europe, there are now 132 currency-hedged ETFs compared with nine in the US and four in Asia. And there is over $21 billion (€15.8 billion) in hedged-ETFs – both the number of products and the AUM have doubled over the last year, according to data from Anthony Christodoulou, founder of WorldTrack.

Products include indices and ETFs covering specific currency pairs and trade-weighted baskets for a particular currency. Xiaowei Kang, senior director of index research and design at S&P Dow Jones Indices, says: “These products make it much easier for retail and wealth investors to take a view on a particular currency.”

Neil Jamieson, head of UK and Ireland for ETF Securities, adds: “Our currency products are designed to track specific pairs, essentially wrapping the forwards into an instrument traded on exchange.”

These products can be used by investors to take a view on a particular currency pair as part of a diversified portfolio. A currency exchange traded product (ETP) allows investors to fully allocate to a currency in the same way that they would allocate to other asset classes.

“It is operationally simple and, because the positions are fully funded, there is no scope for margin calls,” says Jamieson.

Tactical use

Currency pairs can also be used for risk management purposes. WorldTrack’s Christodoulou, says: “If a client had a 20 percent exposure to the US dollar through their allocation to multiple US equity indices, we could reduce the exposure by buying a single ETF that was short the dollar relative to sterling.”

Christodoulou uses leveraged ETFs tactically, for example, three times levered so that he would only need to commit 5percent of the capital to hedge a 15percent exposure.

Some providers have also developed a range of index and ETF products, which essentially package quantitative systematic strategies into indices, for example, carry trade and momentum.

The carry trade is probably the best known strategy: it involves selling a currency with a low-interest rate and using the funds to buy a currency with a higher interest rate. The returns on the strategy can be increased by using leverage.

But these systematic strategies have neither performed well nor have they attracted many assets. That is not all that surprising: it has not been the right market environment for these strategies, particularly the carry trade.

For the carry trade strategy to make money there has to be a difference in the interest rates between different economies. But with most developed central banks keeping interest rates at very low levels, there have been limited arbitrage opportunities.

S&P’s Kang says: “The opportunity for making money out a carry trade strategy has really declined over the past decade.”

And Martin Arnold, research analyst at ETF securities, agrees: “The carry trade has become a very unpopular strategy.”

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