If war is hell, then what is a currency war?

The past few years have seen a so-called race to the bottom as central banks in a number of nations have enacted monetary easing policies aimed at devaluing their currencies to make their exports cheaper and to revive their listless economies. Other nations have cried foul and have responded by taking––or talking about taking––measures to weaken their own currencies to protect their economic interests.

This tit for tat has been trumpeted as a currency war, and some observers believe this competitive devaluation is risky business for global economies and consumers. Others say it’s not much different from the usual jousting that goes on between countries. Either way, such monetary mayhem can impact investors’ portfolios even if they don’t directly invest in the vast foreign exchange market.

“If you own a foreign mutual fund, an international ETF or foreign bonds, then you’re holding international currencies,” says Alex Depetris, the chief operating officer and portfolio manager at Deutsche Bank’s U.S. exchange-traded products division.

And that matters for investors because when the dollar is weak the returns from international assets are worth more in U.S. dollars (and vice versa). It also impacts the financials of U.S.-based corporations with significant overseas operations when they account for currency translation.

Lately, it seems the heavy hand of central banks around the globe has played an outsized role in forex markets. Meanwhile, the influx of exchange-traded products plying international markets has made it easier for people to invest overseas, exposing them to two types of investment risk: those in the underlying securities and those in the currency movements themselves. “Most investors in foreign securities aren’t pursuing a currency trading strategy to mitigate currency risk,” Depetris says.

Given the increasingly assertive moves by central bankers, maybe they should. Scott Mather, a portfolio manager at the recently launched Pimco Foreign Currency Strategy Exchange-Traded Fund (FORX), calls the current situation a currency “skirmish” that could escalate into something nastier.

“We expect it could heat up further,” he says. “That could introduce more volatility down the road, and if it gets out of hand it could damage the real economy.”

Forex Fracas
Currency wars are nothing new. The 1930s witnessed a forex donnybrook when countries jettisoned the gold standard and devalued their currencies for competitive reasons, which accentuated Depression-era trade wars. And various emerging markets engaged in their own version of a currency war for much of the past two decades by intervening or imposing capital controls.

Some critics claim the U.S. launched the latest forex fracas in late 2008 when the Federal Reserve pushed the federal funds target rate to close to 0%, with subsequent promises to keep it at historically low levels until the unemployment rate falls to 6.5%, as long as inflation isn’t a threat. Then came three rounds of quantitative easing (the third round is ongoing) where the Fed has printed money (by electronically expanding the credit in its own bank account) to buy large amounts of assets––mainly mortgage-backed securities and longer-term Treasurys.

QE aimed to create demand for those securities to raise their prices and correspondingly reduce their yields, or interest rates, which theoretically encourages borrowing and spending activity needed to fuel economic growth.

China, Great Britain, Japan and Switzerland are among the other major economic players in recent years that have intentionally weakened their currencies. China is now letting its currency rise to shift its economic emphasis from exports to domestic consumption.

Investors seeking higher returns on the fixed-income side have turned to countries with stronger currencies and, thus, higher interest rates. But in 2010 the finance minister of one such country, Brazil, raised the alarm about a brewing currency war and imposed capital controls to relieve pressure on the Brazilian real and keep its exports competitive.

This past February, nations at the G-20 meeting in Moscow pledged to abstain from competitive devaluation of their currencies. But since then, the U.K. has openly discussed how the British economy could benefit from a weaker pound, and the nominee to be Bank of Japan governor said he would do whatever it takes (read: currency devaluation) to end that nation’s long-standing deflation.

Meanwhile, nations with strong currencies such as South Korea, New Zealand and Norway have indicated they might take steps to weaken their currencies to protect their economies.

Currency Cues
Investors can approach currencies a number of ways. For starters, they can participate directly in the forex market, the world’s largest financial market (at $4 trillion) and its most liquid (trading 24/7 from 5 p.m. Sunday to 5 p.m. Friday Eastern time in the U.S.).

Forex trades are paired trades where you go long one currency and short the other. But forex is a volatile market to trade in with lots of moving parts, and with no limits on leverage, it’s a great way to lose your shirt. Instead, many retail investors, financial advisors and even money managers prefer to address currency concerns through other means.

Nathan Rowader, who runs the Forward Strategic Alternatives Fund (ASAFX), sees the Fed’s monetary intervention as a cue to invest overseas. “I think about currency from a long-term perspective in that the extremely low interest rates in the U.S. will eventually rise, and you can take advantage of that by allocating more to international companies which should outperform on a relative basis versus U.S. companies,” he says.

But it helps to understand what drives currencies in overseas markets. “The currencies in Australia and Canada—which are more tied to materials companies and commodities—are perhaps overvalued, and that creates a headwind because stocks in those countries might be undermined by currency effects,” he says.

Peter Schiff, CEO and chief global strategist at Euro Pacific Capital Inc., believes countries participating in a currency war are committing economic suicide. “All countries are being irresponsible to a degree,” he says. “The question is finding the countries that are the least irresponsible.”

He says the firm’s EuroPac International Bond Fund (EPIBX) owns a basket of short-term bonds, sovereign debt and high-quality corporate bonds that could appreciate the most against the U.S. dollar. Its top holdings include securities from Singapore, Norway, Sweden, Australia, New Zealand and Switzerland. “These are the countries I think are the least bad,” Schiff says. “The Swedish krona and Norwegian krone will go up even if the governments try to keep them down.”

Schiff posits that the crushing debt burdens and inflationary central bank policies in many developed nations make gold a good long-term bet. “I think the only legitimate winner in a currency war will be gold because it will appreciate in terms of all currencies,” he says.

Single Vs. Basket
Many advisors and their clients prefer to approach currencies through mutual funds and exchange-traded products, which come in a variety of flavors. Guggenheim Investments’ CurrencyShares series of ETPs, for example, are trusts that invest directly in a single currency. Each fund holds the currency indicated by the trust’s name––such as the CurrencyShares Australian Dollar Trust (FXA) or the CurrencyShares Chinese Renminbi Trust (FXCH)—and holds them in depository accounts. Investors benefit when the currency rises against the U.S. dollar, and they can also collect a dividend based on the prevailing interest rate in a fund’s targeted country.

Investors who believe the U.S.’s bloated debt and loose monetary policies will take the dollar into the sewer can go with the PowerShares DB US Dollar Index Bearish Trust (UDN), which tracks the Deutsche Bank Short US Dollar Futures Index composed of short futures contracts against the U.S. dollar. Investors who are bullish on the U.S. dollar can opt for the PowerShares DB US Dollar Index Bullish Trust (UUP).

But single currency bets can be quite volatile, so investors can spread around the risk with funds based on a basket of currencies. The PowerShares DB G10 Currency Harvest Trust (DBV) tracks an index composed of both long and short futures positions. The long positions are on the three G-10 currencies associated with the highest interest rates while the short futures positions are on the three currencies with the lowest interest rates. This is a traditional carry trade strategy that entails selling a currency with a low interest rate and buying a different currency with a higher rate in hopes of capturing the difference between the rates. As of early March, the fund was long on the Norwegian krone and the Australian and New Zealand dollars, and was short on the euro, the Japanese yen and the Swiss franc.

Merk Investments takes an active approach to managing currency risk with its four currency-focused mutual funds. Its flagship fund, the Merk Hard Currency Fund (MERKX), invests in a basket of currencies from countries management believes have sound monetary policies and should rise against the U.S. dollar.

As of January 31, its top holding by far was the euro (34.7%). Other leading holdings included the Norwegian krone and Swedish krona, as well as the Canadian, Singaporean and Australian dollars. Gold (at 8.4%) was another sizable holding.

Axel Merk, the company’s president and chief investment officer, says he favors the euro because of its combination of fundamentals and valuation. “I like the euro partly because everyone hates it,” he says. He believes the Australian dollar has the best fundamentals among major currencies, but he’s lightened up on it lately because of its valuation.

The Pimco Foreign Currency Strategy Exchange-Traded Fund, which launched in February, is an actively managed fund that invests in local currencies, currency forward contracts and bonds it expects to rise against the dollar. Its top five country holdings are Canada, Norway, Sweden, Russia and Mexico.

Portfolio manager Scott Mather says Pimco favors currencies with favorable yields from countries with low debt levels, current account surpluses and central banks that “are tolerant of currency appreciation.”

Asset Allocation
Many investors believe the Fed’s monetary easing policies will debase the dollar, cause inflation and crimp consumer spending power. And they view currency-related trades as a hedge against the fall of the U.S. dollar and rising interest rates.

Funny thing, though, is that the U.S. dollar hasn’t tanked yet because it remains a safe haven when global markets tumble. As a result, some financial advisors hedge their dollar hedge by investing in both local- and U.S. dollar-denominated bond funds.

Anthony Welch, a certified financial planner at Sarasota Capital Strategies in Osprey, Fla., invests in three local currency-denominated bond funds: the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC); the WisdomTree Asia Local Debt Fund (ALD); and the WisdomTree Emerging Markets Local Debt Fund (ELD). He also puts clients into the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) and the iShares JPMorgan USD Emerging Markets Bond Fund (EMB), which are dollar-denominated funds.

“Some [local-currency funds] have had a nice run but have tapered off a little as the dollar has strengthened,” Welch says.

Morningstar tracks 27 ETFs in its currency category. The 20 currency mutual funds (and their various share classes) it follows are a subset of its overall “alternative funds” category. Michael Cirami, co-portfolio manager of the Eaton Vance Diversified Currency Income Fund (EAIIX), says he won’t quibble with the alternatives label but he believes currency funds should be considered part of a portfolio’s fixed-income bucket because they have similar risk-reward profiles. He also notes that currencies are a diversification play because of their historically low correlations to traditional asset classes.

EAIIX invests mainly in local-denominated short-term sovereign bills and currency forwards. The fund’s trailing 12-month distribution yield was 4.6%. Its five-year annualized return of 3.8% (as of March 8) is tops in a category where the collective five-year return was a paltry 0.55%.

The fund’s highly diversified holdings span Asia (South Korea, Malaysia, China, the Philippines, Thailand and Sri Lanka are favorites there); Europe (Turkey, Russia, Poland and Serbia rate highly); and Latin America (Peru, Mexico and Colombia are top picks). It has much smaller stakes in Africa (thumbs up for Nigeria and down for South Africa).

Cirami doesn’t buy the currency war hype, and says it might actually provide better opportunities for currency investors with longer-term horizons. The way he sees it, when emerging market countries fight back against the appreciation of their currencies it keeps them from rising too rapidly. “You’d earn [large] currency appreciation in a year, and then the trade would be over,” he says.

But if things go right, the battle against appreciation enables investors to capture both the interest rate and currency appreciation premium over a longer time period of maybe two or three years.

“As long as you have the fundamentals on your side, you’re paid to wait,” Cirami says.