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ETF Specialist

Nobody Ever Got Rich Holding Cash

Currency ETFs have their uses, just not as long-term investments.

In the past year, cash became a very appealing place to be. Believe us, we know--our own Hands-On tactical portfolio had nearly 60% of assets in cash through much of the crisis. However, as the economy bottoms out (as it seems to be doing) and risk appetites return, we have looked to get back into assets that can generate returns over the longer term, or at least save us from the potential ramifications of today's loose monetary policy. The quick stimulus spending and cheap cash churned out by the U.S. government and Federal Reserve seem to have helped avoid a Great Depression-style collapse, but it will be extremely difficult in the future for policymakers to steer between the Scylla and Charybdis of excessive tightening triggering a new recession and continued lax monetary policy generating rampant inflation. In this tricky investment environment, we have heard that a new class of ETF is being offered as the answer: currency funds.

The excitement began in earnest with this Wall Street Journal article about China wanting to diversify its reserves away from the U.S. dollar. Zhou Xiaochuan, the head of China's central bank, had given a speech that listed problems with the dollar as a dominant reserve currency and obliquely referenced an old idea of John Maynard Keynes for a global reserve currency called the "Bancor" backed by a diversified basket of commodities. As news came in April that China had been buying up copper, theories began to abound about China's plans for the stockpiled metal and potential moves toward backing its currency with commodities instead of U.S. dollars. By switching away from U.S. Treasury securities and toward commodities or other currencies as a reserve investment, China would simultaneously weaken the U.S. dollar and strengthen its own renminbi (also known as the yuan) over the long term. When we also consider China's strong economic growth, small deficits, and large net exports, the future of the renminbi looks bright. However, that does not mean it will make a good investment.

The Rise of Currency ETFs
WisdomTree Dreyfus Chinese Yuan  and Market Vectors Renminbi/USD ETN  made a splash when they came out last year as investors sought relief from the market carnage. Even more assets sit in various currency ETFs perceived as longer-term safe havens, whether it is due to their stricter inflation-targeting central bank ( CurrencyShares Euro Trust  (FXE)), a longstanding status as a low-inflation store of value ( CurrencyShares Japanese Yen (FXY)), or a commodity-supported economy that should be buoyed by global inflation ( CurrencyShares Australian Dollar (FXA) and  CurrencyShares Canadian Dollar (FXC)). While these currency funds held up well last year as every other asset class collapsed, they will likely only provide drag on a portfolio over the long run. This should not come as a surprise because currency ETFs are nothing but cash, albeit cash held in a different economy.

Long-Term Returns? Only With Hefty Risk
The vast majority of currency ETFs represent stakes in an interest-bearing bank account denominated in a foreign currency. They derive all their return from two sources: the cash yield of the foreign currency over the expense ratio of the fund and changes in the exchange rate against the dollar. Developed markets may provide somewhat higher yields than the U.S., but their lack of sustained faster economic development and stable monetary system mean that their cash rates will scarcely outpace inflation in the long run. Similarly, currency appreciation over the long run tends to occur only in rough proportion to the difference between production growth rates and inflation. While a boost from rising commodity exports or lower inflation may help a currency's exchange rate against the dollar temporarily, it would be hard for another G10 economy to outpace American growth for an extended period. Unless U.S. policymakers severely screw up and hyperinflation ensues, no developed economy is likely to see its currency appreciate enough to compete with bond or stock returns.

So if developed-economy currencies are out, perhaps emerging-markets currencies offer the potential for sustained faster economic growth and higher yields. Unfortunately, only a handful of currencies offer higher yields than those available on high-grade bonds today, and they carry considerable risk. The Brazilian real yields over 11% today and appears stable with the backing of its mineral wealth, but it lost nearly half its value as recently as 2001-02, as well as having extremely steep devaluations in January 1999 and early 1994. The South African rand yields 8%, but lost nearly half its value in 2000-01 and fell nearly 30% just in late 2008. The Turkish lira yields 9.5% but also lost 30% of its value in late 2008, as well as losing nearly all of its value to hyperinflation through much of the 1990s. Stable emerging-markets currencies offer little return in cash rates, with the Chilean peso yielding only about 1%, and the much-heralded Chinese yuan actually demanding a negative interest rate for U.S. investors. Clearly, a safe yield will not provide any potential long-term returns to these currencies.

 

Even When They Succeed, Currency Investments Fail
For an idea of the potential upside to long-term currency investments, let's take a known success story from the past: Japan in the 1970s and 1980s when it transformed from a promising emerging economy to one of the richest countries in the world. Over that period, the Japanese yen rose from 358 to the dollar in the first days of 1971 to 134 to the dollar in the beginning of 1991, giving an annual return from currency appreciation of 5%. Over that period, cash yields on the yen averaged a bit over 5%, giving a total annual return to a U.S. investor of over 10%. Not bad, until you consider that U.S. inflation over that same period averaged 6.25%, leaving only a 4% real return on one of the best possible long-term currency plays in history. Over that same period, investors with conviction in Japanese growth would have gotten an incredible 21% average return by investing in the stock market (even holding through the crash of 1991 and 1992 would have left an 18% average annual return for the whole period). When everything comes together for a great currency investment, local stock market or long-term bonds provide even better return potential along with the same currency exposure.

Got Any Better Ideas?
Now that we've rained on the currencies parade, what alternatives would we suggest for these diversifying and hedging investments? Well, that depends on your risk tolerance and views about the future. The many different reasons people came to currency investments suggest different alternatives.

Investors concerned about runaway inflation in the U.S. and seeking the support and safety of tangible assets produced by commodity-rich countries may just want to invest directly in the commodities themselves. Gold, the eternal inflation hedge, is easily purchasable through  SPDR Gold Shares (GLD). (For more on the historical performance of gold during recessions, see this article.) Otherwise, we recommend  iPath Dow Jones-AIG Commodity Index ETN  (DJP) or  PowerShares DB Commodity Index (DBC) for more diversified commodity exposures including oil, grains, and industrial metals alongside substantial stakes in gold.

Investors who mostly want to avoid exposure to the U.S. dollar but remain fairly sanguine about other developed economies may want to just increase their diversified exposure to foreign stocks and bonds.  Vanguard FTSE All-World ex-US (VEU) gives a one-stop portfolio covering developed and emerging markets worldwide for a mere 0.20% expense ratio. Rock-bottom Japanese yields keep down the return potential of most international bond funds, but SPDR DB International Government Inflation-Protected Bond (WIP) avoids yen-denominated bonds to offer a real yield of nearly 3% with currency exposure that ranges across the euro, pound, and krona with smaller exposures to more stable emerging currencies.

Finally, investors with a deep belief in the long-term growth of emerging economies should look for better ways to participate than through currency appreciation alone. Risk-averse investors may just want to look at emerging-markets bonds that will at least provide some extra yield. The cheapest option out there in this category is PowerShares Emerging Markets Sovereign Debt (PCY), which also avoids concentrating assets in the bonds of any one country through its approximate equal-weighting methodology. Many of these bonds are dollar-denominated, which means they will not fully participate in emerging-markets currency appreciation, but they will also avoid collapse if any countries devalue their currency.

However, for investors with an eye toward the rise of emerging economies and a time horizon in the decades, we recommend emerging-markets small-cap equities. These tiny stocks obviously provide a great diversifier to U.S. and developed-markets equities that make up the bulk of most investors' portfolios, but they also provide the best pure-play on local growth in developing countries. While emerging-markets large-cap stocks include lots of large commodity producers and exporters who sell to a global market, small caps concentrate in the consumer discretionary, consumer staples, and business services sectors that will ultimately gain most from increased consumption and faster growth. The two best alternatives in this narrow niche are SPDR S&P Emerging Markets Small Cap (EWX) and  WisdomTree Emerging Markets Small Cap Dividend (DGS), which adds a value tilt to the asset class.

 

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