How an Average Investor Should Use Currency ETFs

By Adam Kritzer

Only three years ago, the first currency exchange traded fund (ETF) was introduced, enabling investors to trade the Euro without having to buy and sell the currency directly. Since then, currency ETFs have exploded in number and scope, such that there are now at least 38 such funds, with more being added every month. Rydex and Powershares are the market leaders, with a combined market share of 80% and nearly $5 Billion in invested capital. There are now funds covering all of the major currencies, and several emerging market currencies, as well as funds tailored for specific purposes and strategies. Given the nature of currency trading (there are necessarily always winners and losers), the current bear market has driven a surge in the popularity of currency ETFs. Also given that the average retail investor is relatively uninterested in 100:1 leverage and 24/7 trading, currency ETFs already represent a viable alternative to direct forex investing. In this guide, I will outline comprehensively how these ETFs can be use to achieve a variety of different investing, trading, and hedging strategies.

Overview of Strategies

Generally speaking, there are several strategies that forex traders can choose to employ. First, there is momentum trading, in which traders attempt to gauge the immediate direction of a currency (or currencies), based primarily on technical analysis. The flip side can be called valuation trading, in which investors make forecasts based on fundamental factors, such as macroeconomic conditions and monetary policy. Then there is the carry trade strategy, in which low-yielding currencies are sold in favor of higher-yielding alternatives, with the goal of earning a spread based on the interest rate differential. Currencies, and their ETF counterparts, can also be used for hedging purposes when investing in stocks and bonds, in order to offset the conversion risk that arises from investing in companies that do business and/or issue securities overseas. Finally, there is currency arbitrage, in which traders aim to exploit short term pricing inefficiencies, in accordance with the rule of triangle arbitrage. WIth the exception of the latter, which has largely become the province of banks and institutions, there are multiple ETF options that can be utilized for each of these strategies.

ETF Versus ETN

There is a subtle, but important distinction within the realm of currency ETFs that should first be understood: Funds versus Notes. [For the purpose of this article, both types of securities will be referred to as "ETFs"]. According to Investopedia, "the difference between ETNs and ETFs comes down to credit risk vs. tracking risk. Because ETNs possess credit risk, if [the issuer] goes bankrupt, the investor may not receive the return he or she was promised. An ETF, on the other hand, has virtually no credit risk, but there is tracking risk involved with holding an ETF. In other words, there is a possibility that the ETF’s returns will differ from its underlying index." Since the inception of the credit crisis, this distinction has take on a new significance, since there is now a very real possibility that ETN issuers could fall into bankruptcy, in which case the ETNs they underwrite would become nearly worthless. Investors have duly noted this possibility, and "the market appears to have spoken against the ETN format for currency investing…ETF providers account for 91% of all currency assets, and the ETNs account for 9%."

Saving Versus Speculation

The ETN/ETF dilemma also captures the notion that there is an inherent element of risk built into investing in currencies. As one analyst noted,"Currency ETFs have two very different risk profiles. On one hand, they closely resemble savings accounts; the ETFs hold cash and invest it with banks to get interest. So when measured in the appropriate foreign currency, your shares are unlikely to gain or lose much value…[However,] If you’re measuring performance in U.S. dollars, floating exchange rates add a speculative flavor to currency ETFs." Moreover, due to their special structure and management fees, these ETFs pay a lower interest rate than one would earn from a savings account, without the safety feature of FDIC insurance. Explains another analyst, "each deposit account will pay slightly less than the currency overnight interest rate. On top of being paid less than normal deposit rate, you get the added indignity of paying…fund expenses." At the same time, it seems reasonable to think of currency investment as the equivalent of investing in a growth stock, where the dividend ratio (i.e. interest rate) is low, but the potential upside from appreciation is high. As with any asset class, it is important to evaluate currency ETFs within the context of one’s personal investment strategy. Those with low risk tolerance for example, would be wise to avoid leveraged currency funds, opting instead for a less volatile ETF, perhaps one that is connected to a basket of major currencies.

Individual Currencies Versus Bulk Currencies

Investors wishing to make momentum or valuation bets in currencies can choose between ETFs that track individual currencies and ETFs that track multiple currencies. Currently there are funds for the US Dollar, Euro, British Pound, Australian Dollar, New Zealand Dollar, Swiss Franc, Canadian Dollar, Japanese Yen, Mexican Peso, Brazilian Real, Swedish Krona, Chinese Yuan, Indian Rupee, Russian Ruble, and South African Rand, spread across six different issuers. With the most popular currencies, namely the Dollar and the Euro, investors can choose between multiple issuers. Some of these funds contain built-in leverage and/or mimic a "short" investment, for investors wishing to bet against a particular currency. Both Powershares and MarketVectors, for example, offer leveraged funds that short the Euro. Also, given that every ETF simultaneously represents a bet for one currency as well as a bet against another currency, investors can bet on the decline of one currency by simply buying the ETF for a counterpart currency.

Of course, one might argue that investing in individual currencies is akin to investing in individual stocks, and hence too risky. Accordingly, investors seeking exposure to the forex markets without limiting themselves to one currency pair can choose between several bundled currency options. There are first the PowerShares DB US Dollar Bullish Fund (UUP) and Bearish Fund (UDN), which are designed "to replicate the performance of being long or short [respectively] the US Dollar against the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc." Then, there is the Barclays Global Emerging Markets Strategy ETN (JEM), comprised of 15 equally weighted currencies. Barclays recently also recently introduced the Emerging Market Asia Fund (AYT), by breaking out "the five Asian currencies from the fifteen that make up JEM and added China, India, and Malaysia. This created a regional bundle of currencies that covers Eastern Asia from South Korea in the north to Indonesia and India in the south." WisdomTree, meanwhile, offers the Emerging Currency Fund (CEW), "designed to provide exposure to money market rates in emerging market countries. A basket of 8 to 12 currencies is selected for the Fund on an annual basis, and the Fund’s assets are invested in equal portions to achieve exposure to these currencies." Of course, in this case, diversification doesn’t necessarily imply less risk, as the credit crisis has not been kind to emerging market currencies, neither individually nor as a group.

Carry Trade Strategy

While the monetary and currency instability generated by the credit crisis has largely destroyed the viability of the carry trade, investors wishing to take their chances anyway with this strategy will no doubt find it easy to use ETFs. Most single-currency ETFs pay interest at a rate that is reflective of interest rate levels offered in that country, thereby enabling investors to theoretically benefit from the (comparatively) tight monetary policy in countries such as Brazil and New Zealand, simply by owning their respective ETFs. In the words of one analyst, "this is as straightforward a comparison as you will find between on-line trading platforms and exchange traded products. The major difference, of course, is that with the on-line trading platform, you can use leverage to enhance earnings or exacerbate losses." Investors can likewise play the unwinding of the carry trade by selling short higher-yielding currencies, in favor of "safer" alternatives such as Dollar and Yen ETFs.

The Barclay’s iPath Optimized Currency Carry Exchange Traded Note (ICI) is another option. This note is linked to an index "designed to reflect the total return of an ‘Intelligent Carry Strategy’ which…seeks to capture the returns that are potentially available from a strategy of investing in high-yielding currencies with the exposure financed by borrowings in low-yielding currencies." In such a way, investors gain access to an optimized portfolio of high-yielding currencies without the hassle and transaction costs of buying them individually, as well as the inherent volatility and arbitrariness of trying to self-balance one’s portfolio.

The PowerShares DB G10 Currency Harvest Fund (DBV) employs a strategy that is similar in approach but different in rationale. "The strategyis to go long the three highest-yielding [G10] currencies leveraged 2-1 and to short the three lowest-yielding currencies with no leverage. The idea is that higher-yielding currencies attract capital at the expense of the lower yielders." In other words, rather than try to earn carry (interest rate spread), the fund instead seeks returns from the appreciation often observed in higher-yielding currencies. "The fund tracks the DB G10 Currency Futures Harvest Index, which follows the interest rates of these currencies and boasts an outstanding track record — it has logged strong performance and low volatility." At the same time, this analyst points out that in focusing on currencies that are alreadybacked by high interest rates, DBV may miss out on the appreciation that results from gradual, but steady interest rate hikes, especially if started from a low base.

Hedging Gold Exposure

Currency ETFs can also be used to hedge exposure to gold prices, which have historically risen and fallen inversely with the Dollar. Accordingly, those wishing to protect themselves against a potential bubble in gold could purchase an ETF that tracks the Dollar; "Some allocation of money against gold’s momentum and in favor of the a dollar’s short-term rise may be prudent, and…you can delve into euro holdings for a loose tandem with gold prices." On the flip side, investors who are worried about a broad loss of confidence affecting all currencies (stemming from monetary and economic stability), could purchase ETFs that track commodities or precious metals.

Hedging Stock Market Exposure

Finally, currency ETFs represent a simple and effective way to hedge against declines in stock prices. Where companies and entire economies are especially dependent on exports (namely Japan and South Korea), currency appreciation can have a severe effect on economic growth. Fortunately, "currency ETFs can be used against ‘currency-induced economic distress’…adding the Yen Shares to a portfolio would neutralize (at least to a certain extent) weakness in Japanese stocks." In addition, investing in overseas companies (whether directly in foreign stocks or through American Depository Receipts [ADRs] issued in the US) carries exchange rate risk, because the investments must ultimately be converted back into Dollars. "When investors are holding a broad range of foreign stocks through broad-based ETFs like the iShares MSCI EAFE Index…their portfolio values are negatively affected by these increases in the value of the dollar against the foreign countries they are invested in." Buying shares in a Dollar-based ETF provides for a natural hedge, and "an investor may be able to offset the negative effect of the currency exchange."

Conclusion

With the inevitable addition of new funds to fill in the gaps, it is safe to say that class of currency ETFs will soon be so comprehensive as to enable the implementation of any kind of currency investing/trading strategy. Excepting only the relatively obscure (and it may not be long before ETFs that track such currencies are introduced), investors also have access to almost of the currencies that are available to those that trade forex directly through brokers. Given the downturn in almost every other asset class, currency ETFs will certainly remain popular for the immediate future.