ETF Bonanza Skirts $5.3 Trillion Market on Outflows: Currencies

May 06, 2014 3:23 am ET

(For a Currencies column daily alert: SALT FXCOL.)

May 6 (Bloomberg) -- Axel Merk has filed the paper work, picked a name and is ready to launch Merk Investments LLC’s first exchange-traded currency fund. Problem is, no one wants to put money into it.

Foreign-exchange ETFs have seen investors withdraw $1.1 billion this year, or 23 percent of assets, according to data compiled by Bloomberg that tracks 47 funds. That’s more than double the amount from funds that invest in commodities, the only other sector to suffer outflows.

The lack of demand underscores the ills facing the $5.3- trillion-a-day currency market, where returns are dwindling as the volatility investors rely on to exploit for profit drops to levels not experienced since before the financial crisis as central banks exert control. Parker Global Strategies LLC’s Global Currency Managers Index, which tracks the performance of 14 hedge funds it considers the best in class, slid 1.5 percent last month, the most since July.

“We are ready to launch tomorrow if needed, but right now there just isn’t sufficient demand,” Merk, 44, who manages the $305 million Merk Hard Currency Fund, said during an April 29 telephone interview from Palo Alto, California. “The environment has not been a healthy one for foreign exchange.”

ETF Growth

Growth in exchanged-traded funds has been among the fastest in the history of finance -- with $2.9 trillion in assets as of the end of December, double that of four years ago. If trends in currency ETFs continue, this would be the third consecutive year of outflows.

Foreign-Exchange ETFs invest in a single currency or basket of currencies. The funds aim to replicate price movements in the foreign-exchange market by holding currencies either directly or through currency-denominated short-term debt instruments.

“Currency ETFs are all about the needs of the end users, and make sense for investors who have a currency bet, but don’t want to deal with the relative hassle of being in the spot market,” Reggie Browne, head of ETF trading at Cantor Fitzgerald LP in New York, said in an April 29 telephone interview. “Everyone doesn’t have easy access to regular currency vehicles, and ETFs offer the tactically oriented, with a very specific call, to execute relatively easily.”

Smallest Class

The $3.5 billion held by currency ETFs is the smallest for any class. While assets have more than doubled since 2007, that’s about half the 245 percent growth rate of the $1.8 trillion U.S. ETF market since the financial crisis erupted in 2007.

U.S. ETFs that invest in global equities have seen inflows of $13.4 billion this year. Investors have put $17.4 billion in global fixed-income ETFs, data compiled by Bloomberg show.

“What we need is a good, old-fashioned stock-market crash, or something along those lines, to remind people that they need to diversify,” Merk said. “Currencies compete against bonds and stocks, and if those just keep going up, then there isn’t much room for currencies for your average investor.”

Providers of currency-based ETFs will have to be more creative with product offerings, said William Belden, managing director in Lisle, Illinois-based Guggenheim Investments. The firm manages $25.1 billion in ETFs, including nine currency ETFs through CurrencyShares, the most of all currency ETF providers.

No Bandwagon

“A lot of the model builders in asset-allocation firms have not jumped onto the currency ETF bandwagon,” Belden, whose CurrencyShares oversees $1.25 billion in currency ETFs, said yesterday in a telephone interview. “The industry continues to be in search of better products that are understood more easily so they can easily be adopted as an asset class where you get return, and not just a device for hedging.”

With more familiar assets performing well, traditional investors in ETFs have little incentive to take on the learning curve for currencies, said Rick Ferri, founder of Portfolio Solutions LLC, a Troy, Michigan–based financial adviser with $1.3 billion in client assets.

“Investors understand stock and bonds, they know what oil is, or wheat, or gold, but we are not using euros on a daily basis, or yen, and for many investors, currencies are just too abstract,” said Ferri, who rarely has clients interested in currency ETFs. “To get interested in currencies, there needs to be more volatility, or a clear event that is easy for people to understand, and we just haven’t seen that.”

Dollar Difference

JPMorgan Chase & Co.’s Group of Seven Volatility Index fell to 6.10 percent on May 2, the lowest level since July 10, 2007, when it hit 6.03. The gauge is below the 10.42 percent average of the past decade.

The prospects of a stronger U.S. economy amid a Europe recovering from multiple debt crises and riskier emerging-market currencies has also been a hindrance to currency trading, said David Woo, the head of global rates and currencies at Bank of America Merrill Lynch in New York.

The U.S. economy is poised to outpace the Group of 10 nations over the next two years, with economic growth in the U.S. poised to accelerate to 3 percent in 2015, the most in a decade, according to economists surveyed by Bloomberg.

“FX is a popular asset class when the dollar is going down and looking like it’s going to get much worse,” said Woo. “The dollar is the reserve currency, and prospects here are so much better than prospects elsewhere. In this atmosphere, why would any investor want to go anywhere else?”

--With assistance from Shin Pei in New York and Christopher Condon in Boston.