How US investors can play the carry trade

By Felix Salmon
November 18, 2009
currency ETCs yesterday, I wasn't aware of the various carry-trade products available on US exchanges. But after a very informative conversation with Morningstar's Bradley Kay this morning, I'm now much more up to speed. And while there's nothing in the US quite like the UK products, there are still a fair few carry-trade vehicles to choose from.

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When I wrote my blog entry on currency ETCs yesterday, I wasn’t aware of the various carry-trade products available on US exchanges. But after a very informative conversation with Morningstar’s Bradley Kay this morning, I’m now much more up to speed. And while there’s nothing in the US quite like the UK products, there are still a fair few carry-trade vehicles to choose from.

First though it’s worth looking at some well-established ETFs which are very bad ways to play the carry trade: the Currency Shares suite of ETFs which aim to mirror the performance of nine different currencies. Of those nine, six pay essentially no interest at all, and the amount of interest they pay is basically at the discretion of Currency Shares. “They should be paying interest,” says Kay, “it’s only when I run the graph and I look at them that I say wow, over periods when there should be positive carry, there’s really nothing there.”

The Currency Shares ETFs, then, are a good way to make a short-term bet on currency movements. But they’re not a good way to play the carry trade in particular, which involves taking advantage of the higher interest rates available in foreign currencies.

Then there are a couple of funds which are simply plays on the direction of the dollar. The PowerShares dollar index funds (UUP is bullish, UDN is bearish) are based on futures, and therefore do accrue local-currency interest in much the same way that the ETCs do. But they’re fundamentally trading vehicles designed to make bets on the direction of the dollar, not to use low dollar interest rates to fund investments in foreign currencies.

Finally there’s a pair of funds which specifically seek to replicate the carry trade — the PowerShares G10 Currency Harvest fund (DBV), and the iPath Optimized Currency Carry fund (ICI). Both of them use futures to capture the full local-currency returns: they’re true carry-trade plays.

There are differences between the two, most notably that DBV is a true ETF, where shareholders own shares in a trust. ICI, by contrast, is an ETN, which means that shareholders are essentially just unsecured creditors of Barclays, who don’t get paid for taking on the Barclays credit risk.

They invest in slightly different things, too: DBV takes the G10 currencies and goes long the three highest-yielding currencies while going short the three lowest-yielding currencies. As a result, it’s either 2x leveraged (if the dollar is not one of those six currencies) or 1.66x leveraged if the dollar is part of the mix. The results can be highly volatile: in the second half of 2008, the fund fell over 30% as the yen (one of the shorts) rose and the Aussie and NZ dollars (the longs) fell.

DBV then is very much a trading vehicle, rather than an investment vehicle. Over the long term it does tend to generate positive returns, and those returns tend to have a nice low correlation with most other asset classes. The problem is that when you really need diversification — when people are panicking and stocks are plunging — is likely to be exactly the same time that this strategy blows up as well, as investors flee risky smaller currencies for the safety of the low-yielding dollar.

ICI is much more conservative, carefully selecting G10 currencies to invest in so as to maximize carry while minimizing volatility. It’s also cheaper than DBV, charging 65bp rather than 75bp per year. But it’s tiny, with a market capitalization of less than $30 million, so I’d stay away for the time being.

And there’s one more fund worth mentioning: the WisdomTree Dreyfus Emerging Currency fund (CEW). It too is quite small, but it invests in all manner of exotic high-yielding currencies, and it’s performed quite well: Kay gives it credit for avoiding the zloty crash. If you really want to play the carry trade, this might be worth a look.

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Comments
8 comments so far

I don’t know why you call DBV a “trading vehicle”. That’s exactly what it isn’t. It’s an investment strategy, not a focused bet. Which is why it’s not popular!

By the way, since most international bond funds avoid Yen, they can be viewed as having an implicit carry trade exposure.

Posted by Max | Report as abusive

Short duration international bond funds especially government ones are an interest paying carry trade play. I expect to see single currency money market type ETFs that invest in a rolling 3 to 6 month short bond for each major currency.

Posted by Tom | Report as abusive

Why this sudden interest by Felix Salmon, the purveyor of grown-up, sensible, advice on investing – i.e. there are no free lunches, so build a long-term highly diversified portfolio, and don’t do anything stupid (i.e. ‘clever’) – in doing something stupid like playing the carry trade.

I don’t understand this.

Posted by sean matthews | Report as abusive

What about any of the numerous retail forex accounts?

Most of them will let you do 10:1 leverage and they all pay interest.

Posted by Ted | Report as abusive

What we need are fixed-income funds for G20+ Sov Debt. Give me an IEF, TLT, and SHY for Switzerland, EU Countries, UK, Aussie, Canada… You get the idea. THEN, give me option of currency-neutrality; list identical funds that hedge the USD cross for each fund.

Bunds? Or Bunds EUR/USD Neutral?

Then, in the next life, list the triple-powerlongs and shorts…

Posted by Pat McGroin | Report as abusive

Yes, the carry trade can make an investor good money. But is important also to use market timing signals for these ETFs to know when to get in and when to get out.

Consider http://invetrics.com

Its daily DJIA index trading signal is up a respectable 68% for the year (as of November 1, 2009) and it is free of charge for individual investors.

Posted by Michael | Report as abusive

Shoeshine, Mister? Carry trade plays?

Posted by Walt French | Report as abusive

Anyone?

Does anyone know the truth behind Berkshire Hathaway Inc looking into further carpet manufacturing companies, after their success with Shaw Industries? My source claims BRK are looking into a specific company Oriental Weavers (ORWE.EY – ORWE.CA)

Please advise if you have further updates on the topic.

Posted by NewYorkInvestor | Report as abusive
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