Currencies generally correlate very little, if at all, with most traditional asset classes such as equities or more alternative asset classes. An allocation to a currency basket as part of a multi-asset portfolio can provide a diversification play and reduce the overall risk. Currency exchange-traded products can help protect against the impact of currency depreciation on a portfolio and even generate returns, say fund managers.
The first ETP launched in 1993; now there is more than $4 trillion invested in over 4,500 exchange-traded products worldwide, according to data from asset manager BlackRock.
An ETP trades on a stock exchange and tracks an underlying benchmark, say the FTSE100, and aims to offer the same return as the benchmark.
Therefore, investors can buy currency exchange-traded products rather than dealing directly in the underlying currency spot or futures markets, which appeals to both institutional and retail investors.
While ETPs focused on equities and bonds have jumped in size in recent years, providers believe investors are now turning to foreign exchange as an asset class, according to Martin Arnold, senior research analyst at ETF Securities.
“[There is] more of an awareness of [the] benefits of currencies in your portfolio that is starting to drive a greater amount of interest,” he says.
“We’re talking to a lot of clients to make them aware [that FX] can provide a unique source of returns outside traditional portfolio allocation, which is equities and bonds.”
Assets under management (AUM) on ETF Securities’ FX platform have jumped by almost a third since the end of 2013, according to Arnold. FXL currently has $564 million assets AUM, compared with $432 million at the end of 2013 and $339 million at the end of 2012.
ETF Securities’ new currency basket ETPs include four tactical currency baskets and one strategic basket in both a bullish and bearish version: US dollar G10 basket; euro G10 basket; pound sterling basket; commodity currency basket; and multi-FX basket. They each track a specific Morgan Stanley index, for example, the commodity currency basket tracks an index that reflects the performance of currencies whose economies rely heavily on the export of commodity assets, including the Australian and Canadian dollars.
Boost ETP – a competitor that specializes in short- and triple-leveraged ETFs and typically attracts small to medium-sized institutions such as wealth managers and stockbrokers – is also keen to tap into investor demand for more sophisticated currency products, says its co-chief executive officer Hector McNeil.
“It is in our plans in the next six month to launch some products as the sophistication of products gets more attuned to what people are looking for. At the moment, the products are very basic, but we will see more strategies in time.”
Currency-hedged ETFs are the latest product to lure investors. Earlier this year, iShares, the largest US provider of exchange-traded funds and owned by BlackRock, launched a new range of currency-hedged ETFs. Investors chasing equity gains but worried about losing out on currency risk are flocking to currency-hedged ETFs, which allow them to lock in an exchange rate on a certain date. Last year, WisdomTree’s Japan Hedge Equity Fund attracted almost $10 billion of funds as investors sought to gain exposure to Japan’ rising stock market but take out their exposure to the yen.
The curse of volatility
Currency hedged ETFs reduce volatility, but can also strip investors of potential upside if the currency swings in their favour, says Axel Merk, president and chief investment officer of Merk Investments. Merk believes that investors are better off actively managing their FX risk as opposed to hedging it out.
“Our view is that 40% of market returns are on currencies, [so] rather than take that out you should actively manage FX risk.”
US-based Merk Investments has had to delay its planned launch of an actively managed currency ETF, despite gaining the requisite regulatory approval, partly due to a lack of the volatility that fuels returns in foreign-exchange trading.
“We have not taken it to market because there is not enough demand. ETFs need sufficient daily volume to encourage other folks to jump in. In an environment where stocks go up every day, it’s a difficult proposition to tell investors to diversify into currencies,” said Merk.
Volatility is predicted to rise eventually from its current historic low, according to the World Bank’s Global Economic Prospects report, published last month. It forecasts that the VIX, a well-known index that measures volatility will increase to -4 in 2015 and 11 in 2016.
Those providers with the most comprehensive range of currency ETPs look set to benefit if and when volatility rises and investors turn to foreign exchange.