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Currency ETFs: A flash in the pan?

Sophisticated investors slow in the uptake
By Imran Ahmed

t was not so many years ago that currency traders dabbled in currencies such as the Deutschemark, French franc and Italian lira. Much has changed since the advent of the euro removed these and other individual European currencies from the map. Amongst these changes has been the democratisation of trading in the foreign exchange markets. Currency trading activity, once the preserve of bank treasuries, is now common with many investor classes including retail investors. In some ways, currency trading is more widely accepted than trading in stocks and bonds. According to the Bank for International Settlements (BIS), daily average turnover in foreign exchange trading has more than tripled from US$1.2 trillion in 2000 to approximately $3.9 trillion in 2010 (the latest year for which BIS data has been compiled).1 Presently, most currency traders, including retailers, buy and sell currencies directly from banks or other financial companies. However, given the enormous size of the currency markets,

ETFs: assets under management (US$ mn)

Asset Class
Equity Fixed Income Commodities Alternatives Asset Allocation Currency Other Total

AUMs
1,361,557 338,910 200,401 5,580 2,827 4,998 18,790 1,933,063

Percentage
70.4% 17.5% 10.4% 0.3% 0.1% 0.3% 1.0% 100.0%

Source: BlackRock ETP Landscape Industry Highlight. December 2012. Accessed on January 23, 2012.

approximately $3 billion.3 In December 2012, there were 24 currency ETFs within the US, with average assets of $160 million each. None of these ETFs have AUMs of $1 billion or more. In fact, most of these currency ETFs are below the $100 million AUM mark.4 Is the relatively poor standing of currency ETFs a signal by investors that currency ETFs have limited relevance

Defenders of currency ETFs argue the instrument provides investors with a user-friendly tool to manage currency exposure, particularly for tactical asset allocation
it is not surprising exchange traded fund (ETF)2 manufacturers have created currency ETF products to entice currency traders money away from the banking sector and into the ETF sector. As at December 2012, there were 147 currency ETFs outstanding globally. The aggregate AUMs of these currency ETFs stood at $5 billion, which is only 0.3% of global ETF AUMs aggregating approximately $1.9 trillion. Moreover, currency ETFs were one of the few ETF classes which saw negative fund flows during 2012, with an outflow of 18 ETFI ASIA 2013 Q1 within the ETF world? Or, is there a need for currency ETFs with investors simply requiring more education on the product? Defenders of currency ETFs argue the instrument provides investors with a user-friendly tool to manage currency exposure, particularly for tactical asset allocation. To be sure, there is some merit in the claim. However, there are many other ways for investors to gain shortterm exposure to different currencies, including through money market funds and deposits. Moreover, the ease and

extent to which currency brokers provide leverage to speculators is not easily matched by traditional stockbrokers. For strategic currency exposure, investors often purchase bonds or equity denominated in a particular currency as currency exposure is an important factor within a larger asset allocation decision. Sophisticated investors find the charm of currency ETFs especially lim i ted. I nst it ut i o na l a nd qu a s iinstitutional investors generally have access to wholesale currency exchange rates owing to relationships with banks or financial custodians. As a result of the large trade sizes typically transacted by such investors they normally obtain screen (exchange) rates from banks. Additionally, it makes little sense for such investors to pay any level of fees or commissions for the privilege of investing in a particular currency. These investors can easily convert currencies and place daily call deposits in virtually any freely tradable global currency.

Areas to exploit
However, not all currencies operate in a fully liberalised trading regime. One large economy which still maintains a level of foreign currency exchange controls is China. While Chinas exchange rate regime has been progressively deregulated during the last few years, it is still not an entirely free currency market. Not all

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make such ETFs economically viable? It seems unlikely, particularly as the breakeven AUM threshold for ETFs rises in line with growing competitive pressures. For institutional investors, currency management strategies generally fall within the purview of treasury departments. Again, it makes little sense for institutions to pay management fees and trading commissions to implement currency strategies. That is, unless the ETF portfolio is customised to meet specific customised objectives; something which a publicly marketed ETF intent on maximising AUMs is unlikely to achieve. In the 20 years since ETFs were first introduced, the ETF universe has grown dramatically. Today it encompasses over 4,700 ETFs.5 The ETF industrys growth has been sustained by healthy demand for low cost and innovative products. In the case of currency ETFs, exotic currency ETFs, e.g. Chinese renminbi, may gain traction, especially where some form of exchange controls restricting unbridled trading activities are in place. Nonetheless, these ETFs will have a limited life as regulated economies like China continue to gradually liberalise their currency regimes. ETFs associated with active currency trading strategies may also find some favour amongst certain investors. However, here too the demand may be limited as many investors opt for currency exposure as a part of more sophisticated fixed income or equity strategies. Currency ETFs may not disappear from the ETF lexicon anytime soon, but they are an unlikely candidate to spearhead the ETF industrys growth in the foreseeable future. 

investors wishing to take positions in the Chinese renminbi may be able to do so. Given the dynamics, size and importance of the Chinese economy, there is investor appetite for the Chinese yuan among international investors. Consequently, specialist Chinese currency ETFs like the US$240 million Wisdom Tree Chinese Yuan ETF (CYB) find support within a narrow niche. Another potential area for currency ETF providers to exploit is funds with strategies focused on actively managing currency exposure. Here too, present market conditions may not be conducive for an ETF to accumulate extensive AUMs. Historically, retail investors have little desire to actively manage currency exposures. The small investors home currency bias is testament to that fact. Critics argue that small investors have never before had any easy options to participate in active currency strategies and they will come around to the idea if such specialist ETFs are available, i.e. supply creates its own demand. That may well be true. But in a world of razorthin ETF fees, will there be enough retail demand translated into AUMs to
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Currency ETFs may not disappear from the ETF lexicon anytime soon, but they are an unlikely candidate to spearhead the ETF industrys growth in the foreseeable future

Triennial Central Bank Survey: Report on global foreign exchange activity in 2010. Bank for International Settlements, December 2010. Accessed on January 23, 2013.  http://www.bis.org/publ/rpfxf10t.pdf For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs).  lackRock ETP Landscape Industry Highlight. December 2012. Accessed on January 23, 2012. B http://www.blackrockinternational.com/content/groups/internationalsite/documents/literature/etfl_industryhilight_dec12.pdf The Irrelevance of Currency ETFs, Paul Baiocchi. Index Universe, December 6, 2012. Accessed January 23, 2013.  http://www.indexuniverse.com/sections/blog/15352-the-irrelevance-of-currency-etfs.html?fullart=1&start=2 ETP Landscape: Industry Highlights. BlackRock, December 31, 2012.

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