Currency funds are actually kind of screwed this year

By Emerging Money>,

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Traders looking for a way to profit from the latest battles in the currency wars have been intrigued by the prospect of earning double-digit dividends from ETFs that invest in foreign currency. But how real are these yields?

The larger of the two funds that tracks the Indian rupee, WisdomTree Dreyfus Rupee ( ICN , quote ), has appreciated 4% year to date while the underlying currency has only recovered 1.9% over that time frame.

A casual investor might attribute that outperformance to manager skill or even a fluke tracking error created by the way currency funds work.

While a portfolio like ICN does trade directly in currency futures contracts, the bulk of the holdings are various types of U.S. Treasury paper and money market instruments selected to mirror developments in the foreign exchange markets.

These holdings will generally generate income from interest payments, unlike the currency contracts themselves, which rise and fall according to prevailing exchange rates.

Because of this, in theory a "currency" ETF can accumulate both capital gains and interest like a traditional bond fund. This cash then needs to be either reinvested or distributed to shareholders in the form of dividends.

In the past, funds tracking relatively strong currencies like the Brazilian real ( BZF , quote ) have paid massive dividends as both their futures trades and their bets in the money markets paid off. BZF, for example, paid an effective dividend of 28.84% last December, while ICN paid 15.74%.

Unless a currency fund pays the dividend, its performance rapidly diverges from the underlying exchange rates, making its mandate meaningless.

Investors who see this might suspect that after the rupee -- and the real, for that matter -- weakened against the dollar last year, the associated funds are now "undervalued" and their effective yields have soared to compensate.

But remember: posted yields are historical only, and do not reflect current performance or future dividend payment decisions.

ICN paid the equivalent of 15.74% last year. This year, its relative outperformance against the rupee has come to maybe 2% that can be paid out to shareholders if it's still there in December.

The money markets aren't helping here. On a pure yield-to-maturity basis, ICN's Treasury bills still pay the roughly 0.08% a year that investors can get anywhere else. Adjusted for fees, and the official SEC "yield" here is a cringe-inducing -0.35%.

In theory, the rupee can soar another 13.74% in the next eight months and ICN can repeat its massive payout from last year. After all, both ICN and the rupee have weakened 9% to 10% since the last dividend announcement, and that's a lot of room to recover.

But in practice, those looking for a reliable annual check from the fund company most likely need to look elsewhere.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks
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