As more investors plow their money into foreign stocks and bonds, not only do they have to pick the right assets but they also have to ensure that they don't end up on the wrong side of a currency swing.
Case in point: European markets rose more than 50% from March 2009 through March 2010, but a steady drop in the euro against the dollar blunted those gains for U.S. investors. That's why more investors are using currency exchange-traded funds as part of their investment strategy. Eliminating currency risk from the equation can help deliver better returns if you make the right call on foreign stocks and bonds.
Let's say you're thinking of investing in France's oil giant Total (TOT) or Germany's Volkswagen (VLKAY). At the same time, you're concerned that the euro might sharply weaken as various economic crises on the continent deepen. To make sure a drop in the euro doesn't erode your hoped-for gains, you could buy the PowerShares DB US Dollar Index Bullish Trust (UUP). The ETF would hedge away any currency risk and let you focus on your stock picks.
Then again, you may be expecting the U.S. dollar to resume its steady downward slide that had been taking place until the Great Recession happened. The dollar has rallied against the Euro ever since on a perceived "flight to quality." The dollar may be seen as a safe haven right now, but as the global economy stabilizes and rebounds, that safe haven status may disappear. If you think that will happen and the dollar will resumes its downward slide, then the PowerShares DB US Dollar Index Bearish Trust (UDN) might be a good choice.
An Array Of Choices
There are currently more than two dozen ETFs that focus on currencies, and a few more appear each year. WisdomTree, for example, has created a range of ETFs to fit ever more distinct niches. The South African rand, the Indian rupee, the Brazilian real and the Chinese yuan are just some of the currencies that you can invest in directly through an ETF.
Rick Harper, WisdomTree's head of currency and fixed income, thinks China is becoming an especially fertile area for investors looking to profit from currency swings. "There have been rapid changes in the Yuan market as the Chinese government has opened up Hong Kong as a place for Yuan-based bank deposits and a futures-based foreign exchange market," he notes.
The WisdomTree Dreyfus Chinese Yuan Fund (CYB) was launched in 2008 to capitalize on the changing currency policies in China. Though the yuan has been slowly appreciating against the dollar in recent years some currency strategists believe it has further to climb. They cite economic theories that suggest a country that runs trade surpluses will eventually see its currency rise in value. By that logic, these same strategists are calling for a long-term drop in the dollar, thanks to our persistent trade deficits.
Time To Carry?
Over the past few decades, many investors may have thought of currency moves in the context of "carry trades." This is a strategy that involves borrowing money in a currency from a country where interest rates are very low and investing in a currency in a country with high interest rates.
This strategy make money because countries that offer high interest rates often see their currencies hold their own or even strengthen. Their currency strengthens as their economies grow at a faster clip than rival economies. The relative high bond yield is often a central bank's way of impeding runaway growth that can fuel inflation.
In the past few years, it's become harder to make money on this strategy, as global economic pressures have pushed down rates in many countries in tandem. "This strategy has nearly equity like returns with much lower volatility under most market conditions, though it is particularly vulnerable to global liquidity crunches," according to a report from the fund-rating firm Morningstar.