2011 could be marked as the year of the currency exchange traded fund as more investors tap these ETFs to diversify away from the dollar, seek safe havens or implement other sophisticated currency strategies in a portfolio.
Before ETFs began covering the currency market, foreign currencies were limited to the foreign exchange market, or forex market. The forex market is the most liquid financial market, as it is backed by trillions of dollars in world currencies, exchanging hands twenty-four seven. Currency moves often reverberate in other asset classes such as stocks.
The currencies are not actually bought or sold on a physical exchange. Instead, banks, corporations and individuals enter agreements on trades, with a majority of trades done between banks.
Forces That Affect Currencies
Yields are a major factor to consider when trading in currencies. If a country's benchmark bond yield decreases, the currency most likely would rise - currencies have a high inverse correlation to bond yields. Since the overall stock market and bond yields generally have a positive correlation, currency ETFs could be a way to diversify a portfolio and help offset potential losses from decreases in bond yields or broad equity markets.
In addition, a country that is heavily reliant on raw materials or commodity exports will also see its currency's strength oscillate, depending on commodity prices. For instance, the Australian dollar has a high correlation to base-metal prices due to the country's heavy exports of raw materials.
Currency ETF traders may also be interested in safe-haven currencies during troubled times. Political stability, low inflation and consistent monetary and fiscal policies are all attributes that make safe-haven currencies attractive. Various currencies, including the U.S. dollar, European euro, Swiss franc, British pound sterling, Canadian dollar, Japanese yen and Australian dollar, have been categorized as safe-haven currencies.
Lately, the euro has been losing its appeal as the financial problems of the Eurozone have yet to subside, and the U.S. dollar has also come under fire as loose monetary and fiscal policies help extend the U.S. deficit. In comparison, fiscal and monetary prudence has helped countries like Switzerland and Japan maintain strong currencies.
Investing in Currencies
ETFs offer the average retail investor a chance to gain exposure to foreign currencies. Prior to the launch of the first currency ETFs, the individual investor would have to gain access to this asset class through the forex market, and most individual investors do not have the resources or capital to enter this market. Through ETFs, an investor may buy and sell currency holdings like stock shares. Potential currency investors now have a wide array of currency ETF or exchange-traded note (ETN) options available.
Currency ETFs provide non-U.S. dollar exposure and offer diversification and hedging through the use of another asset class, which may also allow an investor to diminish overall risk while maintaining a position to benefit from the potential upside.
Currency ETFs can try to reflect the performance of a single currency or a basket of currencies. Fund sponsors structure their currency products to try to mimic foreign currency movements by holding the targeted foreign currency or currency denominated short-term debt, but fund structures vary between different fund providers and their management styles.
For example, Rydex's CurrencyShares are grantor trusts that hold the actual currency. The interest earned is accrued on a daily basis and then reinvested monthly.
PowerShares currency ETFs hold futures contracts and are registered as open-ended ETFs. It should be noted that potential gains on futures contracts are subject to the so-called 60/40 tax treatment, where 60% of gains are long-term and 40%are short-term.
WisdomTree's currency income ETFs hold U.S. money market securities or a combination of money market instruments that try to reflect exposure to non-U.S. money market securities or rates.
Market Vectors provides currency ETNs, which are senior, unsecured debt securities that offer exposure to exchange rates between the U.S. dollar and foreign currencies.
In addition, Market Vectors and ProShares also include some leveraged-long and leveraged-short ETNs that provide enhanced exposure. The funds try to provide the double daily bullish/bearish performance of a specific currency.
Barclay's iPath currency ETNs try to reflect the fluctuations in various currency pairs.
Capitalizing On The Carry Trade
Due to the ever-changing values of foreign currencies, the carry trade is becoming a popular strategy to implement. Carry trades try to capitalize on the interest rate disparity between two countries and establish positions for potential appreciation in values.
Essentially, the carry trade involves borrowing currencies from low interest-rate bearing countries and putting that money into countries with high interest rates. As a result, the trader would take advantage of the spread in interest rates between the two countries, and the carry trader may also benefit from potential capital appreciation between the two currencies. Currency investors have traditionally benefited from the carry trade between the high interest found in the Australian dollar against the low-interest bearing Japanese yen.
However, a trader would take a hit if the exchange rate devalues by more than the average annual yield, and the risk of losses is increased if a currency trader uses leverage.
There are numerous ETFs and ETNs targeting currencies, allowing investors to have a range of choices when it comes to deciding how to use them in portfolios. When choosing currency ETFs, consider the differences between the funds, how they access currencies and their tax treatment. Keep in mind the macroeconomic market forces that sway the movements of economies and global currencies. There may be new opportunities in foreign markets, and currency ETFs can be a good way to access the new trends in the global markets.
Full disclosure: Tom Lydon is a board member of Rydex|SGI.