Currency ETF Spotlight: WisdomTree’s CEW

by on October 8, 2009 | ETFs Mentioned:

Over the last decade, the ETF industry has grown from a handful of exchange-traded products offering quick, cheap, and easy exposure to major U.S. equity benchmarks to more than 850 funds that facilitate investment in nearly every asset class, strategy, and corner of the world imaginable. With so many innovative products hitting the market (September alone saw a dozen new product launches), it can be difficult for funds to truly distinguish themselves from the pack. But occasionally ETFs come along that make us scratch our heads, amazed that someone hadn’t thought of the idea sooner. The WisdomTree Dreyfus Emerging Currency Fund (CEW) is one of those funds. 

Banknotes At the British Museum In LondonThe currency ETF space in particular has seen a great deal of innovation, expanding from products that offer simple exposure to exchange rates between two countries (a space covered by the CurrencyShares line of funds) to more complex and diversified exposure. CEW seeks to provide returns that reflect both money market rates in certain emerging market economies and changes in the value of these currencies relative to the U.S. dollar. Actively-managed by an investment team, CEW holds a basket of 8 to 12 currencies that meet certain liquidity requirements. When the fund launched in May of this year, it maintained equal exposure to 11 different currencies in three broad regions:

CEW Constituent Currencies
Latin America EMEA Asia
Mexican Peso South African Rand Chinese Yuan
Brazilian Real Polish Zloty South Korean Won
Chilean Peso Israeli Shekel Taiwanese Dollar
Turkish New Lira Indian Rupee

The investment thesis behind CEW is relatively simple, but quite compelling: (1) emerging markets offer U.S. investors potential for attractive risk-adjusted returns, (2) diversification, both within a portfolio and within asset classes, is a good thing, and (3) the future of the U.S. dollar is highly uncertain, facing significant downward pressure on a number of fronts.

Emerging Market Exposure…With Lower Volatility

Over the last several decades, emerging market economies have delivered tremendous returns for U.S. investors, significantly outpacing U.S. and other developed markets. The dichotomy between developed and emerging markets is perhaps best illustrated by China’s “slowdown” during the recent global recession. GDP in the U.S. is expected to decline slightly in 2009, while some developed European countries are anticipating economic contractions approaching double digits. Yet China’s growth is expected to slow to about 8%.

The promise of emerging markets doesn’t stop with China. Brazil’s new found oil wealth and Olympic success has given the Latin American country hope for improved infrastructure, social services, and quality of living. Poland has managed to sidestep the reaches of recession, and may be among the only European economies to expand in 2009. India’s election of a pro-business government earlier this year has instilled optimism over the country’s long-term growth prospects. But perhaps the strongest indication of future strength in emerging markets came last month in Pittsburgh when the G-20 countries agreed to increase the voting power of developing countries at the International Monetary Fund.

But this reward hasn’t come without a commensurate amount of risk and volatility. Many emerging markets, particularly those with commodity-intensive economies, have seen wild swings over the last year as the markets bottomed out in March and subsequently staged a dramatic rally.

Over the last decade, emerging market currencies have shown significantly lower volatility than equities. According to WisdomTree (PDF), over the last ten years an equally weighted basket of emerging currencies had an annualized volatility of 7.1%, while an equally weighted basket of emerging market stocks from the same countries had a volatility of 25.6%.

Diversification Benefits

Investments in foreign money markets have generally maintained low correlations with traditional asset classes, such as domestic equities, fixed income, and commodities, making them potentially valuable additions to investor portfolios. But if exposure to one emerging money market investment is good, exposure to 11 is better. By their very nature, investments in emerging markets are risky. But by weighting the exposure to included countries equally, CEW spreads the risk around, meaning that the impact of a catastrophic event in one country (such as a currency devaluation) will have a much smaller impact on CEW.

Incorporating a moderate amount of exposure to emerging money market instruments can reduce overall volatility of a portfolio, but it may also enhance overall returns. As of June 30, the one-month deposit rate available to U.S. investors on the basket of emerging market currencies included within CEW was 2.8%, more than four times the comparable yield for the Euro zone (0.6%) and ten times the U.S. rate (a measly 0.2%).

Crumbling Greenback?

The U.S. dollar has seen been weighed down by a number of factors so far in 2009, and the road ahead doesn’t appear to be getting any easier. Calls to replace the greenback as the world’s reserve currency have been gaining momentum, and concerns over the intermediate and long term impacts of the recent stimulus plans are a cause for significant anxiety among many investors.

China, the largest investor in U.S. Treasuries, has begun shifting its reserve holdings into hard currencies such as gold and silver, and is encouraging its citizens to do the same. Some analysts believe that losing reserve currency status to the Euro isn’t nearly as far-fetched as it once seemed.

Emerging Asian economies are expected to begin raising interest rates over the next quarter, months before the U.S. economy will potentially be strong enough for the Federal Reserve to consider similar action. It seems that a once unlikely scenario is beginning to play out, as the emerging markets take the lead on the path to a global recovery from the recent financial crisis. As rates around the world rise, the dollar is likely to face continued downward pressure, particularly if unforeseen events force the Fed to keep rates low throughout 2010.

Since its inception in May of this year CEW has gained about 7.1%, thanks in part to a slumping greenback. Over the same period, the PowerShares DB U.S. Dollar Index Bearish (UDN), which is designed to replicate the performance of being short the dollar against major developed market currencies (including the pound, yen, and euro) gained about 6.5%.

Cheap and Liquid

Since being launched in May, CEW has accumulated assets of nearly $50 million, and continues to see cash inflows on a monthly basis. With an average daily volume of nearly 30,000 shares, liquidity shouldn’t be much of an issue for CEW. Nor should its fees. An expense ratio of 0.55% is a bargain for currency ETFs, and an outright steal for an actively managed fund. By comparison, the Dent Tactical ETF (DENT) maintains an expense ratio of 1.5%.

For more information about currency investing, see:

Disclosure: No positions at time of writing.