Global currency market turnover has risen substantially the past few years, from an average of $3.3 trillion a day in April 2007 to $4 trillion in 2010. The increase has been driven largely by increased trading activity by hedge funds, pension funds, mutual funds and insurance companies, where turnover rose by 42%, according to the Bank for International Settlements. There are several reasons why investor demand for currency exposure is increasing: low correlations to traditional asset classes, inherent market inefficiencies and potential profit opportunities, relatively low volatility and high levels of liquidity.

The growth of the currency market has occurred amid a global financial crisis and subsequent crash in the value of many financial assets. The financial crisis of 2008 may have acted as a catalyst in increasing demand for currency exposure. Many investors came to the harsh realization that their portfolios were not adequately diversified to protect against downside risk. The currency asset class, which can exhibit low correlations to traditional classes as well as an attractive risk/return profile, may help solve this problem.

As a result of increased demand, many new currency mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) have launched in the past few years. Advisors and their clients now have greater options available for currency investing, a trend that is likely to continue as the currency asset class becomes an established component of portfolios. Currency mutual funds, ETFs and ETNs all share similarities, and each displays unique characteristics and distinct risk and return profiles. Investors should be aware of these differences when considering a currency investment.

 

THREE FLAVORS

Aggregate assets under management for listed currency funds grew at an annualized pace, topping 75% from 2004 through 2010. At the end of 2004, total assets managed in listed currency funds totaled $244 million; at the end of 2010, they stood at $7.1 billion.

At the end of 2004, only one currency mutual fund was available. The first currency ETF launched in 2005 and the first currency ETN in 2007. Since then, we have seen rapid growth in the number of investments available. By the end of last year, there were 44 listed currency investment instruments-13 currency mutual funds, 21 ETFs and 10 ETNs.

Generally, currency investment vehicles can be classified as either static baskets or managed baskets, and directional or nondirectional in investment approach. Static baskets refer to set positions in a defined basket of currencies, or a basket that is predetermined by some set formula (in many cases the "basket" is a single currency), whereas a managed basket vehicle refers to an actively managed basket of currencies, often with no predetermined allocation.

* Currency mutual funds. Mutual funds tend to follow a managed basket investment approach, and may be both directional and nondirectional. A directional approach is a specified position in a managed basket of currencies relative to one currency, typically either long or short the U.S. dollar. A nondirectional strategy has no predetermined view on any one currency.

Currency mutual funds typically invest in wide baskets of currencies and don't track a predefined index. Therefore, the portfolio rebalancing and management of currency exposures tend to be driven by the fund manager

* Currency ETFs and ETNs. ETFs and ETNs tend to be static baskets, with many vehicles following a directional investment approach. The objective of most ETFs or ETNs is to track an underlying index or benchmark reliably, less any expense ratio. Generally, a currency ETF or ETN will have a defined index before it is launched.

The simpler the index, the easier it is for a manager to track it. As such, currency ETFs and ETNs take a simple directional approach to currency investing. For currencies, the simplest index is often to track the value of one currency, as measured in U.S. dollars. As of Dec. 31, 2010, 24 of the 31 listed currency ETFs and ETNs were aimed at tracking a single currency. These included three leveraged instruments aimed at replicating 200% of the performance of the particular currency.

As opposed to an ETF, an ETN is not registered under the Investment Company Act of 1940. Rather, an ETN is a debt instrument. This is an often overlooked, yet critical aspect of an ETN. There is counterparty risk with ETNs; investors should understand that while the objective of an ETN is to provide returns that track some definable benchmark or index, ultimately the financial health of the issuer may have a marked effect on whether coupons, or even the principal of an ETN, will actually be paid.

 

CHOOSING THE RIGHT ONE

Deciding whether to invest in a currency ETF or ETN, or a currency mutual fund, is like deciding whether to invest in an individual equity or an equity mutual fund. In general, when investing in an ETF or ETN, planners must first understand the underlying index and formulate an opinion on the index. In many instances, the underlying index is a single currency, so advisors must ask themselves whether they believe that currency will appreciate or depreciate, and over what time frame.

Many currency ETFs and ETNs are better suited for short-term, tactical investors who have strong convictions on one currency or another, or a small basket of currencies, over a specified time frame. Holding periods may be short, sometimes intraday, so the ability to trade ETFs and ETNs multiple times a day can be advantageous for such investors.

Currency mutual funds, on the other hand, may be more suited to investors who want diversification and the attractive risk/return profile of the currency asset class over the medium to long term. These investors don't want to speculate on short-term price movements.

Another consideration is the flexibility the different vehicles have with respect to trading currencies. Currencies can be traded 24 hours every business day, yet ETFs and ETNs can typically only rebalance during U.S. trading hours. Currency mutual funds are often able to trade while U.S. markets are closed. This can be beneficial should significant news flow occur overnight, and with regard to some of the less liquid currencies available, which may exhibit higher levels of liquidity at times when U.S. markets are closed. For example, select Asian currencies are often more liquid during Asian trading hours.

 

VOLATILITY AND EXPENSES

Because the value of currency ETFs and ETNs is typically tied to a one-way view on one currency, or a small basket of currencies, their returns have historically been more volatile than those of currency mutual funds, which typically invest in a larger basket of currencies. Note that currency mutual funds have the ability to adjust allocations in a way that minimizes expected volatility of returns. In fact, many currency mutual funds specifically employ such a strategy in the overall allocation process.

The chart in "Safer Bet," at left, depicts annualized volatility of returns for unleveraged currency mutual funds and ETFs/ETNs for 2008, 2009 and through June 30, 2010. The annualized volatility of the S&P 500 (unleveraged) is also included.

Currency ETFs and ETNs tend to follow simpler investment approaches relative to mutual funds and have lower fee structures. As of Dec. 31, 2010, the average ETF and ETN expense ratio was 0.54%, while the average currency mutual fund charged 1.47%.

Some currency mutual funds have front-end and/or back-end sales loads in addition to a management fee, although no-load funds are available. These additional fees and higher expense ratios are generally representative of an active management approach.

Leveraged funds have higher expense ratios as the use of leverage typically generates interest expenses, which tend to be reflected in the overall expense ratio. Another consideration is the tax implications of the various investment vehicles.

An advisor's objective has a big bearing on which type of currency vehicle is most suitable. If clients take a more tactical, short-term approach to investing and are willing to accept a higher level of volatility, they may prefer ETFs or ETNs. Clients seeking diversification benefits over the medium and long term would likely prefer mutual funds.

 

Axel Merk is president and chief investment officer of Merk Investments, the manager of Merk Funds. Kieran Osborne, CFA, is co-portfolio manager of the Merk Absolute Return Currency Fund.