The Best Way To Play China's Currency

• By Murray Coleman
• On 12:33 pm EDT, Wednesday July 22, 2009

[Editor's note:The following is an excerpt of an article that appeared in the April edition of the Exchange-Traded Funds Report. Subscribers can find the full story here.]

Investors looking for a bastion of stability, and potentially some upside, could do worse than a Chinese currency ETF or ETN.

Prior to 2005, the Chinese yuan (also known as the renminbi) was directly pegged to the U.S. dollar. The Chinese government relaxed that peg in 2005, and has allowed the currency to slowly appreciate against the dollar ever since. But the government still keeps a tight rein on things, never allowing the currency to deviate that much from the dollar peg.

There are a lot of people who think it should. It’s become de rigueur for politicians to call for China to allow its currency to appreciate against the dollar. The feeling is that China is deliberately setting the peg below market rates as a way to make its exports more attractive.

If you believe that—and if you believe China will continue to relax the peg—investing in the yuan could make sense.

Accessing The Market

Investors looking for access can choose between two exchange-traded products:the Market Vectors – Chinese Renminbi/USD ETN (NYSE Arca:CNY) and the WisdomTree Dreyfus Chinese Yuan Fund (NYSE Arca:CYB).

Both target similar returns. CNY tracks an index of nondeliverable yuan forward contracts, which tend to correlate highly (but not perfectly) with spot currency movements. CYB also uses forward currency contracts to access ultrashort-term Chinese bonds. Think of both almost as Chinese money market funds.

CYB is actively managed by WisdomTree’s partner, Mellon Capital, a big currency player.

Its managers have flexibility to try to find the best forward contracts with maturities ranging from one to three months.

Dealing in such short maturities raises the question of how active Mellon’s managers can be, but the market for yuan-based forward contracts measures some $3 billion per day, so there’s clearly some wiggle room.

ETF Vs. ETN

A much bigger difference than active versus passive comes with the structure of the funds:CNY is an exchange-traded note, while CYB is an exchange-traded fund.

As an ETN, CNY is actually a debt instrument. That means investors are exposed to the credit risk of the underlying bank. In this case, CNY is issued by Morgan Stanley. Morgan Stanley is generally considered one of the stronger U.S. banks, but at the moment, the entire Financials sector remains in question.

---

Last year, we saw CNY suffer temporarily from its exposure to Morgan Stanley. In September, when the credit crisis was in full bore and investors were worried about a Morgan Stanley default, prices for CNY spiked down as much as 10% on a handful of days.

Its bid/ask spread during that period also fluctuated within a wide range. Each time, CNY quickly recovered its losses, but that volatility served as a reminder:Were Morgan Stanley to actually default, holders of CNY would join other creditors looking for pennies on the dollar.

CYB, by contrast, barely moved on the days that CNY fell. As a traditional ETF, CYB’s value does not depend on the credit of any single bank, making it less volatile than CYB.

That’s not to say CYB has zero counterparty risk. Since the fund uses forward futures contracts to gain exposure to the market, it does court some such risk. But it’s extremely limited. That’s because when you enter into a forward contract no cash is initially exchanged. Instead, two parties agree to make payments to each other based on the change in value of a given contract. Those payments are typically settled on a daily basis. The credit risk is limited to any change in value that occurs between settlements.

A second major difference between the two products comes in how they pay out income.

CYB, like a traditional currency or fixed-income fund, makes quarterly income distributions. CNY, by contrast, doesn’t pay out interest income. Instead, any income the ETN would have received is added to the share value of the note. That could create problems for some investors, as the IRS has ruled that investors must pay taxes each year on such so-called notional interest.

It’s also important to note that CYB and CNY probably won’t win many fixed-income performance contests. Funds with longer-term maturities over the years should provide much greater returns. As with any relatively short-term bond or money market fund, shaving expenses to squeeze out more profits is a wise strategy. So far, their yields have tracked fairly closely, but CYB has a lower expense ratio (0.45%) than CNY (0.55%).

Buzz up!