Publish date:

Currency ETFs Gain Traction

Assets in funds that track yen are surging as investors bet on further appreciation.

For years, big investors have used exchange-traded funds that track major equity indexes to jump in and out of the stock market. Now some newer ETFs that track currencies are coming into their own as trading vehicles, too.

Rydex's 22-month old

CurrencyShares Euro Trust

(FXE) - Get Report

, which has nearly $1 billion in assets, was the first currency ETF to attract a significant following. It now has a close rival, the

CurrencyShares Japanese Yen Trust

(FXY) - Get Report

. Rydex says assets in the seven-month-old ETF are surging as investors use it to capitalize on the falling dollar and the unwinding of the carry trade.

For the third quarter through Sept. 20 the ETF has pulled in $332.4 million of new money, or 67% of the $490 million in assets it held on June 30.

Including capital appreciation, total assets for the Yen Trust surged 77% through Sept. 20 to $866.2 million.

Barclays' iPath

JPY/USD Exchange Rate

(JYN)

is also benefiting from the yen's appreciation. The exchange-traded note, which debuted in May, pulled in $25.3 million for the third quarter through Sept. 20. It has total asset of $87 million.

TheStreet Recommends

"That's pretty significant," says Ron Delegge, editor and publisher of ETFguide.com. "To get that kind of flow into a product like this says that these types of products are gaining acceptance in the market place as hedging instruments."

Both products are benefiting from well-timed launches. For years, investors have profited by borrowing yen at very low interest rates (the Bank of Japan's overnight rate is currently 0.5%) and converting the money into dollars in order to buy higher-yielding assets such as U.S. equities or bonds. They pocket the difference, or spread, between the interest rates paid on the borrowed money and the return on their investments.

Because the money is borrowed, profits are potentially magnified to four or five times the interest-rate spread.

But this trade has become increasingly unattractive this year as falling U.S. interest rates and expectations that Japanese rates could rise are pushing the value of the yen higher against the dollar. During last month's global credit crunch, many retail Japanese investors who had borrowed money to invest in the U.S. were asked to deposit additional funds as security against their loans.

Naomi Fink, senior currency strategist at French investment bank BNP Paribas, says retail Japanese investors had margined foreign exchange positions between five trillion and six trillion yen. In order to meet margin calls, they had to sell their dollar-denominated investments and exchange the proceeds back into yen.

This big move out of U.S. assets caused the yen to jump even higher against the dollar, resulting in a quick profit for investors in the two ETFs that track the Japanese currency. So far this quarter, both the Yen Trust and the JPY/USD Exchange Rate have returned 7%.

Although much of the carry trade has now been unwound, some people believe the yen has further room to rally. "The dollar is oversold and where it goes from here I don't know," says Peter Boockvar, an equity strategist at New York brokerage Miller Tabak. "But as long as the Fed pays more attention to trying to generate growth at the expense of dollars and inflation, the weakness should continue."

Fink of BNP Paribas says that while the dollar appears to have stabilized against the yen, retail Japanese investors still have a lot of outstanding margin positions. This leads her to believe there could be another sharp move in the exchange rate as more carry positions are unwound.

"Now is a good time to buy to catch that upward move," says Fink, adding, "We're very bullish in yen. It's very cheap compared to almost every other currency out there."

Still, not everyone is enamored with the currency.

"I think the yen is a dangerous currency to hold because the Bank of Japan says it reserves the right to raise interest rates, because it doesn't want to slip back into deflation," says Axel Merk, portfolio manager of the

(MERKX) - Get Report

Merk Hard Currency Fund (MERKX), which invests in a basket of currencies, but doesn't hold yen. "If you are an investor in the yen, you have to be very careful."

Both the ETF and the ETN charge an expense ratio of 0.4%, but investors in the ETF need to pay annual taxes on the interest they earn, while ETN investors don't incur taxes until they sell their shares.