Don’t Hedge Currency Risk – Embrace It (FXE, UUP, FXY, CYB, BZF, ELD)

Joseph Hogue:  The Financial Times reported Tuesday that the FTSE index group has created an index of eleven currencies and two commodities for use by investors to hedge against currency and inflation risk. The “Wealth Preservation Unit” includes the world’s seven largest currencies and those of Brazil, Russia, India and China, as well as a 4.5 percent weighting in gold and oil.

The US dollar will constitute 23.3% of the index. Currency weights will generally be apportioned by the country’s percentage share of global GDP with a minimum weight of 0.25%, meaning that the BRICs currencies will account for around 17.7% of the index.

The index is not tradable, but will be followed by fund products replicating its performance.

The general idea is that with the vast amount of quantitative easing over the last three years, both explicit and implicit, investors need a vehicle to remove the external risk of currency losses from their portfolio. According to FTSE:

The aim of WPU is to construct a basket of currencies and commodities that preserves the long-term real wealth of investors by reducing the external risk of loss arising from variations in the relative valuation of currencies and the internal risk of loss arising as a consequence of a general reduction in purchasing power. (full document and methodology)

The index will be adjusted regularly, keeping each currency weight according to percentage of world GDP. As the developing markets gain a higher share of the world’s economy, their index weight will grow and investors will be gradually moved into more exposure.

The most obvious problem is the one prevalent in most indices: that constituents are selected based on an arbitrary factor unrelated to performance or projected performance.

In fact, we can be fairly certain over the long-term that the currencies constituting the vast majority of the index will depreciate against those in the emerging world. A need for hedging across the developed currencies may be necessary for investors with large stakes in these countries, but this is unrelated to the need for long-term debasement protection and available through existing funds like a combination of the CurrencyShares Euro Trust (NYSEArca:FXE), the CurrencyShares Yen Trust (NYSEArca:FXY) and the PowerShares DB USD Fund (NYSEArca:UUP).

Short-term traders have a myriad of individual currency funds with which to hedge or speculate including the WisdomTree Chinese Yuan Fund (NYSEArca:CYB) and the WisdomTree Brazilian Real Fund (NYSEArca:BZF).

The long-term investor will want exposure to emerging currencies through bond and equity funds. Though currency funds are also available, the exposure to bond and equity funds will allow for both asset appreciation, income, and exposure to purchasing power protection from a debasement of developed market currencies. In January, we highlighted the WisdomTree Emerging Market Local Debt (NYSEArca:ELD) as a good opportunity within the bond space.

While the proliferation of indexes generally gives investors a way to fine-tune their investment strategy, investors need to understand the construction and relevance behind their indexed investments. While useful for hedging, actively and directly selecting investments for expected return rather than an arbitrary characteristic is often the better approach.

Written By Joseph Hogue From Emerging Money

Emerging Money provides insightful and timely information about the increasingly important world of Emerging Market investments.  CNBC Emerging Markets Contributor Tim Seymour leads the team of  Emerging Money to bring you cutting edge global news and analysis.

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