Currency markets are like the proverbial white elephant in the living room-an unmistakable presence that is hard to miss, yet tempting for investors to ignore. With average daily turnover of $3.2 trillion, the daily currency turnover is more than ten times that of all of the world's equity markets combined. Institutional investors use currency exchange for hedging, while commercial banks use it to manage cash flow.

To most financial advisors, however, direct currency market investments for hedging or speculation remain little more than a curiosity. Until recently, the complexity associated with the foreign exchange market kept most investors out of the game. With more than 30 currency ETFs now available, sponsors such as Barclays, PowerShares and Rydex are hoping that will change.

At the beginning of December, currency ETFs held some $6.3 billion in assets, up from $3.7 billion a year earlier. While that's miniscule next to the $356 billion in U.S. equity ETFs and less than half the amount in real estate ETFs, their popularity has picked up steam recently. The group took in some $1.7 billion in October and November alone, about two-thirds of the $2.56 billion in total inflows through November 2009. "Every other day we seem to get a call or e-mail asking about foreign currency funds," observes Morningstar analyst Bradley Kay.

Introduced about five years ago, currency ETFs and exchange-traded notes take a number of forms and are offered by Barclays, PowerShares, ProShares, Rydex and WisdomTree/Dreyfus. Some are based on single currencies such as the euro, the Japanese yen or the Swiss franc, while others use currency baskets. Share prices fluctuate based on currency movements against the dollar. If the greenback weakens against the named currency or currency group, the ETFs will rise in value. If the dollar strengthens against the named currency, the ETF loses ground. Some are leveraged to enhance currency moves. Others try to capitalize on a strengthening dollar.

Given their modest trading volume, it is clear that the buzz surrounding currency ETFs has not translated into activity for most investors. Certainly, there are other ways to navigate or take advantage of currency moves. Simply increasing international allocations when a weakening dollar provides a currency lift can have a huge impact on portfolio returns. In 2007, a year when the greenback slid, the total return for the MSCI EAFE Index was 11.63% for U.S. dollar investors, nearly triple the take for local currency investors. Those who want a currency-neutral strategy can turn to a number of actively managed mutual funds that minimize or eliminate the impact of dollar fluctuations on their portfolios through internal currency hedges.

Currency ETFs take those simple techniques a step further by allowing investors to tailor currency positions more precisely and make tactical speculative moves more adroitly. Someone who likes prospects for international markets over those in the U.S. but who is concerned about the currency impact of a strengthening dollar, for example, might implement a simple hedge on all or part of an international allocation by using a broad-based ETF such as the PowerShares DB U.S. Dollar Bullish Fund (UUP). A tactical speculator might simply buy an ETF representing a currency he believes will outgun the U.S. dollar, or short such an ETF if he thinks the dollar will outperform. One way to heighten exposure to a weakening dollar would be to couple a foreign ETF holding with a single or basket currency ETF that bets against the dollar.

Institutional investors use currencies in less obvious ways that financial advisors could replicate with the ETFs. Since most currency ETFs and ETNs pay local rates of interest, they may earn more than cash investments in the U.S. and can be used to diversify cash investments. "Carry trade" strategies, a common institutional technique used to profit from interest rate differentials among countries, are also a possibility.
Some see the new ETFs as a convenient entry point for investors to test unfamiliar waters. "ETFs offer efficient ways to invest in foreign currencies," noted Morgan Stanley analyst Dominic Maister in a recent report. "In our view, the costs for many investors associated with currency ETFs may be lower than the costs associated with trading and investing in other currency-related investments."

Morningstar's Bradley Kay believes currency ETFs can be useful, but only under limited circumstances. He notes in a recent report that the funds will not provide much economic return beyond changes in the exchange rate when used as a small, supplementary holding in a typical portfolio. "So what if your Chinese yuan fund goes up 15% if your larger U.S. bond and equity holdings have collapsed?" he asks. "Currency funds have their place, but mostly as a replacement for cash that would otherwise be held in a U.S. dollar-denominated money market fund."
Another argument against currency investments is simply that over long periods, currency moves tend to even out. Since it has been argued that long-term expected returns are essentially zero, a currency overlay for long-term holdings would seem to make little sense.

Kay believes one possible application for the funds would be to hedge travel expenses. Someone planning an extended trip to Europe when the euro is cheap, for example, could invest roughly the equivalent of anticipated expenses in a euro-pegged ETF such as CurrencyShares Euro Trust (FXE) or the iPath EUR/USD Exchange Rate ETN (ERO) to eliminate the risk of a sudden appreciation in the euro.

But sponsors say the benefits of currency ETFs extend well beyond the narrow niche of sophisticated foreign travelers. They can be a good diversifier because they have a low or negative correlation to stocks, bonds, real estate and commodities. Over a recent ten-year period, the average correlation to the U.S. Dollar Index, which measures the movement of a basket of major international currencies against the U.S. dollar, was negative for fixed income, foreign equities, gold and commodities and only slightly positive for U.S. equities. They are often less volatile than some investments, including most stock indices. An ETF pegged to the euro has a beta of .43 relative to the Standard & Poor's 500 index, while an Australian dollar ETF's beta is .69.

Offerings and product structure vary among the sponsors. Rydex's CurrencyShares, the oldest members of the group, cover the euro, Japanese yen, the Australian dollar, the Mexican peso and other currencies. Structured as grantor trusts, CurrencyShares assets are invested in interest-generating time deposits. According to Maister, they are not FDIC-insured and they assume the credit risk of JP Morgan Chase, the depository bank. Investors are taxed on the ordinary interest income they have received over the year and when they sell, they will realize a gain or loss that is taxable as ordinary income.

PowerShares has three basket currency investments. The DB U.S. Dollar Bullish Fund (UUP) and its bearish equivalent (UDN) use currency futures contracts to go long or short the U.S. dollar against a basket of six major currencies. The DB G10 Currency Harvest Fund (DBV) is a carry-trade investment that seeks to exploit the appreciation potential of high-yielding currencies versus low-yielding currencies. The funds can realize gains during the year as positions are liquidated or rolled. Sixty percent of the gains from the futures contracts are subject to long-term capital gains treatment, while 40% of the gains are taxed at less favorable short-term rates.

The WisdomTree/Dreyfus lineup includes ETFs based on the Brazilian real, emerging currencies, the euro and the Chinese yuan. The developed market products invest very short-term investment-grade money market securities denominated in the non-U.S. currency specified in its name. Because money market securities are less readily available in emerging markets, the ETFs use a combination of U.S. money market securities and forward currency contracts.

Barclays and Market Vectors offer single-country and group currency products structured as exchange-traded notes, or ETNs. The notes, structured as debt instruments, are designed to track currency moves more precisely than ETFs but expose shareholders to the risk of the bank that backs them. (For more information on the pros and cons of ETNs, see "Wading Back In," Financial Advisor, September 2009.) ProShares weighs in with four volatile ETFs that use leverage to enhance movements of the dollar against the yen and euro.

Any currency ETF investment is only profitable if currency moves, which are notoriously difficult to predict, play out. For much of 2009, a weakening dollar provided a tailwind for the U.S. stock market, since it increases profits for U.S. companies that do business overseas. On the other hand, the dollar's rally against the euro from 1.60 in mid-2008 to 1.25 in 2009 illustrates how boldly, and quickly, a trend can reverse. If a U.S. economic recovery outpaces recoveries in Europe and other overseas locales, the U.S. dollar would likely appreciate against other currencies. If that happens, the appeal of many of the ETFs on the market would head south.