Hedge Fund Results, But No Hedge Fund Fees

Over the last few years, ETFs have been introducing individual investors to a rapidly expanding universe of potential diversifiers at a tiny fraction of the fees charged by actively managed hedge funds. One such "hedge-fund-light" strategy is the "carry trade," one of the oldest strategies in finance, in which an investor borrows money in a currency with low interest rates and invests it in another with higher interest rates.  PowerShares DB G10 Currency Harvest  leverages a quantitative strategy building a long-short portfolio based upon academic research to give individuals an easy way to invest the carry trade as a small part of a long-term portfolio.

This trade takes advantage of the historic pattern that higher-yielding currencies tend to maintain their exchange rate against lower-yielding currencies or even appreciate slightly, allowing the trader to pocket the difference in the currency yields (also known as the carry). The strategy is easily leveraged given its frequently low volatility and reliance on futures contracts, allowing higher returns than the mere 2% to 4% annual short-term interest-rate spreads between developed economies.

PowerShares DB G10 Currency Harvest and its underlying index utilize a 2x leverage, as it shorts three currencies for the total notional value of its assets and goes long in another three currencies for the notional amount of its assets. Additional yield comes from investing the collateral cash for the futures contracts in T-bills, boosting long-run historical returns of this strategy to around 6%-8% after fees, or slightly less than stocks.

Investors should be aware that the carry trade has an unusual returns distribution compared with more traditional asset classes like stocks, bonds, and diversifier asset classes such as commodities. The carry trade depends highly on global liquidity and macroeconomic stability, as that allows the high yields and steady exchange rates which make the scheme profitable. However, when liquidity suddenly dries up in a global economic crisis such as we've just seen, this can cause a flight to safety by global investors. This flood of capital from the higher-yielding currencies in previously high-flying economies to the more stable but low-yielding dollar and yen causes sudden large losses for the carry trade after years of relatively steady gains.

As this fund will lose value at the same time that bonds and stocks head south in a global recession, it is not the holy grail of diversification. Still, it provides a great source of steady returns in the large majority of years when we are not suffering through a major economic crisis, and that alone can add considerable value as a long-term holding with occasional rebalancing.

A fundamental view of this fund would require predicting the complex interplay of central banks, short-term bond markets, and macroeconomic events that determines future interest rates and currency exchange rates, a problem so difficult that it has thwarted every economist's attempt to produce an accurate model. However, we can speak in very broad strokes about some major factors likely to affect this strategy's performance over the course of this economic crisis.

We have seen this fund bounce back strongly in 2009 as the global appetite for risk returned. Long positions in the commodity-fueled Norwegian krone and China-led Australian dollar paid off handsomely, along with some bounce-back in the New Zealand dollar from its 2008 savaging. These rebounding currencies are all nearing their mid-2008 highs against the U.S. dollar and euro, meaning that we may be approaching the end of strong FX appreciation as a driver for exceptional carry trade returns. As the risk trade slows down, expect lower returns over a couple of years as commodity prices remain below their 2008 peak and developed-world stagnation weighs slightly on emerging-markets growth.

Portfolio Construction
This fund is based on the Deutsche Bank G10 Currency Future Harvest Excess Return Index, which invests in long and short three-month currency futures in order to capture the spreads on the risk-free yields between the different currencies. Each quarter, it rebalances by first identifying the three-month Libor rate in each of the G10 currencies: U.S. dollars, Canadian dollars, Japanese yen, Australian dollars, New Zealand dollars, British pounds, euros, Swiss francs, Norwegian krone, and Swedish krona. The fund then buys long positions equal to one third of the fund's assets in three-month futures for each of the three highest-yielding currencies and sells short positions equal to one third of the fund's assets in three-month futures for each of the three lowest-yielding currencies. If the U.S. dollar is one of the six currencies that yields the least or the most, that long or short position is ignored for the quarter and the fund has only 1.66x leverage from the other five futures positions. While using the fund's cash as collateral for the futures contracts, management also invests the assets in three-month T-bills to provide additional yield above the benchmark index.

Fees
PowerShares DB G10 Currency Harvest has an expense ratio of 0.75%, which is more expensive than most ordinary currency ETFs. However, it is typical for ETFs and ETNs that seek to produce returns uncorrelated to other asset classes through long-short strategies and substantially cheaper than equivalent open-end funds.

Alternatives
The only close alternative to this fund would be  iPath Optimized Currency Carry ETN (ICI), issued and backed by Barclays. As an exchange-traded note, ICI will produce no taxable income, but it will also expose the shareholder to credit risk from Barclays Bank PLC. Its index also invests solely in G10 currencies and tends to use less leverage than the DB G10 Currency Harvest index, which kept it from losing too much in 2008 but also led to far lower returns in the 2009 rebound.

Anyone looking to speculate on particular currencies should instead use a currency-specific fund, as this ETF's currency positions can change with each quarterly rebalancing.

Investors looking for a long-term holding in alternative asset classes to diversify their core portfolio may also want to consider the commodity managed futures fund  ELEMENTS S&P CTI ETN , which uses a long-short momentum strategy to profit from persisting macroeconomic and supply trends.

Morningstar has Premium Analyst Reports similar to this on more than 300 ETFs. Test-drive our research for 14 days with a free Premium Membership trial.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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