China ETF's 'Yuaning' Gap

By JOHN JANNARONE Investors keen to hitch a ride on the Chinese yuan should do their homework. Worries about the dollar have prompted large inflows into exchange-traded funds invested in alternative-asset classes, such as gold. The yuan also has appeal, with expectations that the Chinese economy will continue to outpace the U.S. and that China will one day allow its currency again to appreciate. Between 2005 and 2008, the yuan rose more than 20% against the dollar, before holding nearly steady for over a year. Unfortunately, the WisdomTree Dreyfus Chinese Yuan Fund, one ETF designed to track the yuan, faces hurdles. Chinese laws prevent foreign investors from holding currency, so the WisdomTree fund invests in derivatives known as nondeliverable forwards. These are bets on future spot prices written with banks. The trouble is that nondeliverable forwards already reflect the market's expectations for currency moves. For example, when China let the yuan rise gradually during the previous revaluation, forward prices often ran ahead of the spot rate. Such a condition, known as contango, would erode the ETF's returns because the fund invests exclusively in one-month forwards. Every month, the ETF would have to pay a premium to replace expiring contracts. A similar problem has caused returns for the U.S. Oil Fund to lag far behind spot prices in recent months. Admittedly, the WisdomTree fund should capture any sudden rise in the yuan. But there is little reason to expect Beijing will change its policy of gradual appreciation in favor of a big one-time move. Betting on the yuan heading higher over time looks sensible. Assuming the fund will match any rise is a much riskier bet. Write to John Jannarone at john.jannarone@wsj.com