Earlier this month, WisdomTree launched the first broad basket of emerging market currencies in the exchange-traded funds space. 

The story was widely covered. (See related article here.)  But it's important to note that while investors will be buying exposure to currency fluctuations, this new fund's fortunes will also be tied to what happens with short-term interest rates. 

Consider the makeup of the WisdomTree Dreyfus Emerging Market Currency Fund (NYSE Arca: CEW). It's designed to deliver currency exposure through trading forward contracts on short-term money market rates in selected emerging market countries. 

The fund has no index, is considered active and rebalances quarterly. However, CEW is likely to act more like an index representing emerging markets money market rates. Where no such index exists, this fund gives exposure to short-term emerging markets rates and currency exchanges, equal-weighting among countries. 

How It Works 

Before this fund, the only ETF coverage of emerging market fixed income did not include currency; something that CEW brings to the ETF market. 

There are two components that drive the return of this fund: income from money market rates, and foreign currency exchange to the U.S. dollar. The fund uses short-term, 90-day, forward contracts to synthetically deliver results similar to holding money market securities in the emerging market countries included in the fund.

Short-term price movements of the fund largely return the mark-to-market of the forward contracts, reflecting changes in currency movements. However, it is both the income and currency component, within the forward contracts, that may be equally important, that together give the total return of the fund.  

According to a press release from WisdomTree on May 6, 2009, Bruce Lavine, WisdomTree president and COO, said this about the new fund:

"Our new Emerging Market fund fills an important void in the ETF landscape by giving investors the first currency basket product delivered in the 1940 Act fund structure. CEW should be attractive to investors interested in diversifying outside the U.S. dollar or accessing a less correlated asset class."

Growth In Emerging Markets 

The 1940 Act Lavine refers to is the Investment Company Act of 1940, which was established to set up mutual funds. This is important when concerning exchange-traded products that are designed to give exposure to currency. Typically, currency products are exchange-traded notes, which are a form of debt issued by the issuing investment bank, and give investors the return of an index.

This also means that tax consequences from long-term gains of the fund will be taxed as capital gains. Distributions from this fund will be paid annually and come from these two factors, according the WisdomTree: income from the fund's investment in U.S. money market securities and foreign currency contracts.

The WisdomTree Dreyfus Emerging Market Currency Fund comes to the market as part of the currency lineup from WisdomTree. WisdomTree has been able to offer this unique exposure to currencies through its expertise in the use of forward contracts inside this kind of product.

The growth potential of emerging markets has been widely discussed and in recent years has driven global economic growth. Growth in these countries can be reflected in their relative currency strength.

Other emerging market bond ETFs invest in emerging market government debt issued in U.S. dollars. CEW can give investors direct currency exposure while removing the risk of taking on more duration, or sensitivity to interest rate movements, that other emerging market debt ETFs carry from longer maturity lengths. 

Interest Rate Risks

The WisdomTree Dreyfus Emerging Market Currency Fund uses 90-day forward contracts to gain comparable exposure to money market rates in emerging market currencies. The fund collateralizes the contracts with U.S. money market securities.

"The advantage of 90 day forward contracts is that you limit the interest rate exposure," said Luciano Siracusano, chief investment officer at WisdomTree. 

Gaining this kind of short-term liquid exposure to a country's money market rates gives investors the least amount of interest rate and short-term inflation risks. However, in the long run, if inflation in an emerging market country becomes out of control, this would devalue its currency.

"Brazil's inflation rate is 5.5%. This is high for us but not for Brazil. Real Rates in Brazil are at 3.7%, making 3 month money yield 9.2%," according to Siracusano.

For Brazil, the effect of this kind of money market and currency combination exposure was "13.9% annualized from March 31, 1999 through March 31, 2009. The lion's share of this gain is coming from interest rates," said Siracusano.

This is an important statement about the features of this kind of investment. Returns are driven by the currency fluctuations and 90-day money market rates, which sometimes can be significant in emerging market economies, compensating investors for taking on the extra risks. 

The one-month deposit rates for the equally weighted basket of emerging market currency to U.S. investors, taking into account both rates and currency exchange, was 3.7 on 5/8/2009, according to WisdomTree. In context, the similar rate in the U.S. is .2% and .7% for both the euro and in the UK. The ranges of the one-month rates as of 5/8/2009 were Taiwan at -2.7% and Brazil at 11.2%. The currency exchange rates can be volatile and WisdomTree, on its Web site, posts the rates weekly.

How Active Is Active? 

This active ETF is really as passive as active gets. Each year, 8 to 12 emerging market currencies are selected for the fund for that next year. Currently, 11 currencies have been selected in the broad regions of Latin America, Europe, Middle East, Africa and Asia. The currency allocation then is equally weighted among the 8 to 12 currency exposures, and each quarter the fund rebalances back to this equal weighting.

The active portion of the fund is on the underlying security level, managing the investments used to meet the objective exposure to each currency, which is meant to be similar to holding money market securities in the respective emerging market country.

According to Siracusano, the emerging market currency ETF is active for two reasons. "Firstly, there was no relevant index and there is also a component of maintaining the flexibility to take action when needed from government involvement."

In short, the active part of this ETF is really from the unavailability of having an available index to track. The real active portion of the ETF is more akin to an administrative management of the forward contracts, something that WisdomTree alone has been able to do.  The objective of the fund is to represent the underlying money market rates. 

The investment committee for this fund meets annually and decides what countries are to be included. Considered are issues like low correlation among the currencies and region exposure, which needs to be "representative of the global emerging market economy. This means monitoring regional exposure, and liquidity of the underlying currency. This was why Russia was excluded this year; liquidity of the underlying currency was too low to effectively trade through forward contracts," according to Siracusano.

All in all, the WisdomTree Dreyfus Emerging Market Currency Fund is set to be competitive in the emerging market bond and emerging market currency category, both with relatively few competitors. Over the long run, currencies and short-term rates may be a smart way to play the significant growth potential in emerging markets while decreasing volatility and duration risks.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He welcomes comments and suggestions for future columns at:  This e-mail address is being protected from spambots. You need JavaScript enabled to view it .