June 11, 2008 at 1:00 am by Tom Lydon
Currency exchange traded funds (ETFs) have helped investors to cash in on the weakness of the U.S. dollar, while giving exposure to foreign currency in the process.
So far this year, the U.S. dollar has been down 7% against the euro and 6% against the Japanese yen. The latest exchange traded products are using leverage to tempt investors to go ahead and bet against the weak U.S. dollar, reports Eleanore Laise for The Wall Street Journal.
But is the timing off? The government is dropping hints that it wants to start turning the currency around, and Federal Reserve Chairman Ben Bernanke said he was ready to start defending the dollar. It’s lost a quarter of its value in the last six years, says Colin Barr for Fortune.
Will the government follow through? While we wait for an answer on that, the products keep coming.
Last month, both WisdomTree and Dreyfus rolled out new ETFs focused on currency in reaction to the latest market conditions. The latest offerings are actually exchange traded notes (ETNs) trying to get a leg up on returns, by magnifying ups and downs:
- Market Vectors Double Long Euro ETN (URR): Tracks an index designed to gain 2% for every 1% gain in the euro relative to the U.S. dollar.
- Market Vectors Double Short Euro ETN (DRR): Provides the opposite exposure, generally gaining 2% for every 1% decline in the euro versus the dollar.
Tags | Asia, ETNs, Europe, Federal Reserve, Japan
June 11th, 2008 at 7:47 am
The use of leverage may be very effective in the short term, but a recent article in the Journal of Financial Planning, raises significant concerns about the use of leveraged ETFs — those that multiply an index to increase the returns.
“Leveraged ETFs: A Risky Double That Doesn’t Multiply
by Two” by William J. Trainor, Ph.D., CFA and Edward A. Baryla, Jr. Ph.D.
Journal of Financial Planning, May 2008. pp 49-55.
http://www.fpanet.org/journal/articles/2008_Issues/jfp0508-art6.cfm
This article investigates the performance of leveraged funds, those funds that are designed to multiply the return of a particular index. However, the ways the funds appear to work, means that the funds have some extra risks associated with them. The study comes to some important conclusions:
While leveraged ETFs can multiply index returns on a day-by-day basis, long run returns can not be multiplied by the same ratio because f a phenomenon known as the constant leverage trap and the lognormal nature of continuously compounded returns.
While many leveraged ETFs meet their specific daily targets, there is quite a bit of volatility related to meeting their targets on any particular day.
After using Monte Carlo simulations, the authors found that a typical 2X leveraged fund magnifies the index return only 1.4 times on an annual basis, for holding periods up to ten years. But the risk, as measured by standard deviations, stays double, or in some cases even quadruples in cases of extreme negative returns.
The authors compare leveraged ETFs to buying an index fund using a margin account and shows that the leveraged ETFS are superior in the long term due to their lower cost.
They caution long term investors to be wary of the risk/return tradeoff of leveraged ETFs, given that these types of funds can have extreme swings in value. However, they note that leveraged ETFs could be useful for short term investors/traders who are willing to take the risk and are taking a distinct position on the market.