Trading the dollar has been a tough game since the Federal Reserve moved toward a tightening bias (kind of) as other central banks try to “ease” their way to prosperity. For traders, currency funds have been the best vehicle to wager on the impact of central bank policies. Traders certainly aren’t lacking in options; there are at least 35 funds offering everything from unlevered or levered single currency funds to basket currency funds offering exposure to developed or emerging markets. But with so many options, determining not just the timing of your trade but the type of product to use is more important than ever.
Buying and selling currencies is a zero-sum game, leading to a “low return for high risk” environment; meaning traders need to guard their profits, something difficult to do with currency funds. Those 35 funds we mentioned have about $3.3 billion in assets, a drop in the $2 trillion-dollar bucket that is the ETF universe and a major reason why they haven’t become more popular as 90% of the assets are concentrated in the top 10 funds. The rest have liquidity issues with high bid-ask spreads for smaller funds, not to mention high fees with CurrencyShares funds setting the floor around 40 basis points with the average fee in the space closer to 60 basis points.
Consider the PowerShares DB US Dollar Bullish ETF (UUP), which was up nearly 25% over nine months from July 2014 to March of 2015 as the Fed’s QE3 tapering lifted hopes for the dollar. That helped the fund add hundreds of millions in new assets just in time for the dollar to flatline with a -1% return for the 12-month period ending Aug. 31, while investors endured an annualized standard deviation of more than 8%--twice that of most bond funds--while paying 90 basis points.
For investors looking to express a longer-term view, currency-hedged ETFs are found across nearly every asset class and are a far more effective way to trade their dollar viewpoint, although at the price of more volatility. Unhedged funds can act as a form of leverage on returns with an extreme example this year in Brazil where stocks have skyrocketed as the political situation stabilized and the dollar lost nearly 20% of its value versus the Brazilian real through August on Fed indecisiveness. Local stocks were up almost 33% in dollar terms, so great profits were to be had depending on the amount of volatility you could endure. Currency traders using the WisdomTree Brazil Real Strategy Fund (BZF) were up more than 33.5% through August, and the unhedged iShares MSCI Brazil Capped ETF (EWZ) was up 63% with nearly 2X the volatility of BZF (see “Real value” below).
That volatility might be one reason why a number of unhedged international bond funds have been gathering serious assets in 2016. EWZ has seen its AUM increase by more than 20% in 2016, while the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC) has seen a 75% increase and the SPDR Barclays Emerging Markets Local Bond ETF (EBND) has had a better than 120% increase. Both offer attractive levels of Brazilian bond exposure, around 14% of their assets, with EMLC holding a diverse portfolio compared to EBND’s focus on government bonds.
That may not sound like much, but both are up close to 14% in 2016 versus an 8.2% return for the category, according to Morningstar, and with drastically reduced volatility, typically less than 60% of that of BZF.
That reduced volatility and broader portfolio could make them much more suitable for investors looking for long-term capital gains.