Global investment patterns have favoured emerging markets and commodity-producing nations for some time now, putting a fresh spotlight on the long tradition of the carry trade.
The carry trade is one of several tactics employed by professional investors betting on foreign currencies. Traders borrow funds in countries with low interest rates and put the money into higher-yielding assets abroad, betting that their gains won't get erased by a sudden change in exchange rates.
With interest rates at historic lows in the U.S. and expected to go still lower, a proverbial tidal wave of U.S. dollars has flooded into the emerging markets of Asia, South America, Central America and Russia, as well as into developed economies underpinned by resources, including Australia, Canada, New Zealand and Norway.
When these capital currents are played properly they can yield robust returns that aren't tied to today's range-bound equity markets. In the last few years, financial institutions, reacting to investor demand, have been creating vehicles in which individuals can access the complicated world of currency trading.
The U.S. asset manager WisdomTree Trust last month launched a commodity currency ETF built on short-term financial instruments of eight of the largest commodity-producing nations, including Canada, Brazil and Russia. The WisdomTree Dreyfus Commodity Currency Fund is the ninth currency income ETF in the firm's stable, which includes funds that bet on the euro, yen, yuan, Brazilian real and Indian rupee.
Chicago's Invesco PowerShares Capital Management LLC runs a fund that bets the U.S. dollar will lose value against a basket of currencies of other developed nations, as well as a fund that is bullish on the future of the greenback. Yet another, PowerShares DB G10 Currency Harvest Fund, is based on currency futures contracts of 10 developed economies including the U.S., Canada, Japan and Sweden.
Similarly, the Barclays iPath Optimized Currency Carry fund places bets on the currencies of the G10 club of nations, using what it calls an "intelligent carry strategy," which tries to profit from the difference between high-yielding and low-yielding currencies.
These ETFs carry management fees in the range of 0.45 per cent to 0.75 per cent. While they offer retail investors greater breadth and more security than direct currency futures, their greatest value to unsophisticated investors may be as a simple hedge to use against investments overseas, especially foreign bonds.
No Wealth Creation in Currencies
Despite the proliferation of new funds, some professional money managers say the smartest way for individuals to gain exposure to foreign currencies is to invest in stocks based in those countries.
"Currency in and amongst itself is not an asset class. There is no economic return or proactive creation of wealth as there is from bonds and stocks," says Michael Nairne, president and chief investment officer of Tacita Capital in Toronto, which manages money for high net worth clients.
Currency trading is also a zero-sum game. For every winning transaction there is a loser on the other side of the deal. It involves matching wits with another trader. Generally, there are three ways traders try to outsmart the market: by figuring out what the central banks are going to do, by calculating inefficiencies between currencies, and by betting with or against the herd instinct.
Mr. Nairne says the currency game favours professionals and high net worth investors with access to the experts. Retail investors are left to make their own bets against institutions, which use very sophisticated models that employ algorithms devised over years of research. In addition, making money on currencies requires a lot of leverage, which in turn demands almost minute-by-minute oversight.
Unhedged Equity
His advice to average investors is to include a reasonable portion of unhedged foreign equity in their portfolios, and to invest in those stocks at a time when the Canadian dollar is strong, such as now. The strategy requires a buy-and-hold approach over the medium to long term, he adds.
Arun Kaul, portfolio manager and chief investment officer of Toronto-based Hillsdale Investment Management Inc., agrees. Over the long term, he believes that the U.S. greenback has to decline against the currencies of developing economies. But in the short term, the currency markets are extremely volatile.
He does not employ any short-term currency speculation at his firm and any retail investor who does is essentially adopting an investment strategy akin to day trading, he says.
Mr. Kaul advises investors looking to play foreign currencies to use ETFs, which will give them a much more balanced approach, or invest in American depositary receipts (ADRs), which trade on U.S stock markets in U.S. dollars and represents ownership in the shares of foreign companies.
Three ETFs to play foreign currencies
Barclays iPath Optimized Currency Carry fund
Annual fee: 0.65 per cent
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Invesco's PowerShares DB G10 Currency Harvest Fund
Annual fee: 0.75 per cent
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WisdomTree Dreyfus Chinese Yuan Fund
Annual fee: 0.45 per cent