ETF Takes Long/Short Approach on Currencies

Last week, a new currency ETF came to market with almost no notice: the PowerShares DB G10 Currency Harvest Fund (DBV Quote).

The fund invests in currencies of the G-10 countries: the euro, yen, Swiss franc, British pound, Norwegian krone, Swedish krona and the Canadian, Australian and New Zealand dollars, but not the greenback, because this ETF is primarily intended as a tool of diversification for U.S. investors. (My colleague Katie Benner introduced the fund last week on the Street.com.)

The strategy is to go long the three highest-yielding currencies leveraged 2-1 and to short the three lowest-yielding currencies with no leverage. The idea is that higher-yielding currencies attract capital at the expense of the lower yielders.

The fund tracks the DB G10 Currency Futures Harvest Index, which follows the interest rates of these currencies and boasts an outstanding track record -- it has logged strong performance and low volatility. The average annual return for the index over the past 10 years has been 11.48% vs. 8.32% for the S&P 500, its correlation to the S&P 500 has only been 0.21, and it has less than half the volatility of the S&P 500. Much less volatility, better returns and low correlation are reasons to explore further.

I'm convinced that the strategy has merit, but as with all strategies, there are flaws that should be understood before purchasing.

Higher yields do tend to make a currency more attractive, but that overlooks an important point: Currencies whose interest rates are moving up tend to be strong. A currency starting from a low base interest rate that is headed higher is likely to be a strong currency, but it could be overlooked by the ETF's strategy.

An example of this is the Swedish krona, which I have written about before and which is a short position in the ETF. Sweden has raised rates several times this year, has better GDP growth and a lower unemployment rate than the eurozone, and a more conservative party won the recent national election. These factors are bullish for the krona, and indeed it has strengthened against both the U.S. dollar and the euro.

The ETF is long the New Zealand dollar, but you may not want a bite of the kiwi. The overnight rate has been the highest of the bunch for several years now and there is visibility for it to stay high for a while still, meaning it could remain a long position in the ETF for some time.

DB G10 Currency Futures Harvest Index

Source: PowerShares

Last week, New Zealand reported a record current account deficit for the second quarter of NZ$15.15 billion ($9.9 billion), approximately 9% of GDP. The current account deficit has tripled in the last three years. This could result in a lower kiwi. The Reserve Bank of New Zealand may be painted into a corner of maintaining a high interest rate to defend a declining currency.

This is not to say that the fund should not be bought. However, the strategy has its limitations, and understanding what could go wrong is important.