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ETFs versus forwards: Which are best to play currency dislocations?

ETFs versus forwards: Which are best to play currency dislocations?

Congressional deadlock is bad for equities and equally bad for bonds, but may spell good news for the US dollar. As a safe haven currency with unparalleled liquidity, it thrives on fear and should strengthen on market uncertainty.

Wrangling over the US debt ceiling and deficit in the weeks ahead should therefore be supportive. But then again, the mess on Capitol Hill could weigh on economic growth, delay any tapering of quantitative easing and depress the dollar.

Stuck between these two forces, of course, the chances are that the dollar will not move significantly. That is what happened during the previous crisis, in the summer of 2011. There was week-to-week volatility, but it started the period – and the year – pretty much where it ended.

Sterling is also caught amid countervailing winds. Over the past few months it has been one of the best performing major currencies, gaining 7% against the US dollar and 5% against the euro, thanks to expectations of a Bank of England interest rate hike, contrasting with more dovish talk from the Federal Reserve and the European Central Bank. Yet this has prompted analysts to roll out phrases such as ‘extremely overbought’, ‘stretched to the upside’, and ‘a pullback may be on the cards’.

For emerging market currencies, the language is bleaker still. ‘For countries with large current account deficits, the possibility of a currency crisis has started to raise its ugly head,’ says Sara Yates, global head of foreign exchange strategy at JP Morgan Private Bank.

Central banks, including those of Brazil, Indonesia and India, have been compelled to defend their currencies by raising interest rates, dampening the growth outlook. The accompanying potential for higher returns from developed economies has aggravated the problem.

The countries mentioned above also face general elections next year, meaning current account deficits are likely to persist as incumbents try to spend their way back into office. In addition to this trio, Yates expresses caution over the prospects for the Turkish and South African currencies.

She is more positive about the Malaysian ringgit, though. It too has been hit by the broader flight from emerging currencies, which she attributes to its liquidity and the high proportion of its bonds owned by foreigners.

‘However, its other fundamentals are healthy,’ she says. ‘Growth is decent, rate hikes may be on the way, and the economy has a current account surplus.’

Sharp movements creating such putative mispricings have enticed many into exchange-traded currency products. ETF Securities, which runs 80 currency vehicles with some £280 million under management, reported flows worth £31 million in September and £76 million so far this year.

Such products offer the ability to make straightforward bets for or against currencies. The ETF Securities range has names along the lines of ‘short euro long US dollar’, based either on macroeconomic analysis or a hunch ahead of a national statistical announcement, for example. George Soros, after all, made fortunes by shorting currencies that with hindsight were in evident peril, so is it an area worth backing?

‘Clients from time to time say that to us,’ says Chris Sexton, investment director at Saunderson House. ‘But we don’t believe we have more than a 50% chance of getting it right. Every time you think a currency is going somewhere, you’re wrong. People say they have an insight, but it’s just a view. They’re really speculating, not investing.’

He isn’t alone in this opinion. ‘The number of people who can predict currencies is very small, if not zero,’ says Alan Miller, founding partner of SCM Private.

Even those who are more optimistic are only marginally so.

‘There is the potential to make some interesting money in currencies,’ says Neil Birrell, senior investment manager at Premier Funds.

He prefers to leave this to the experts, which in his case means GAM Star Discretionary FX, a fund managed by Adrian Owens that has returned 10.2% over the past year.

While GAM provides the currency upside, Birrell hedges the downside through forward contracts, considering them ‘cheaper and more efficient’ than currency exchange traded notes (ETNs).

Elizabeth Savage (pictured), research director at Rathbones, also prefers to use currency forwards for hedging because they are cheaper.

The reason is simply the upfront and ongoing costs. Exchange traded products incur transaction fees, followed by annual management charges. An astute forward contract, on the other hand, should have a minimal arrangement fee and only cost the holder if the currency moves the wrong way – in which case the long position that has been hedged should result in a net profit anyway.

Currency ETNs are also eschewed by many because of their structure: essentially they are unsecured debt issued by the counterparty bank, rather than a basket of assets in the traditional sense of exchange traded funds (ETFs). Miller asserts that he would ‘never, ever’ touch an ETN.

‘They simply don’t have the same degree of protection of ETFs,’ he says. ‘They are the equivalent of backing Finchley United against Manchester United in terms of investor protection. I’ll stick with Manchester United.’

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