Alternative Views: The Pros & Cons Of Currency ETFs

August 13, 2008

Here's a rundown of what these ETFs are designed to do—and what they're not. Hint: They're a very different sort of animal.

Anthony WelchCurrency exchange-traded funds have rapidly grown in popularity as investors and advisors seek refuge from an increasingly convoluted stock market.

These types of ETFs tend to have lower volatility and usually have longer and more defined trends than stock indexes. Many currency funds also feature monthly dividend payments as well.

And as the Wall Street media increases the coverage of the U.S. dollar and how it impacts various other areas of high finance, investors are becoming more aware of how currencies and other alternative assets can play a role in a diversified portfolio.

However, it is important for investors to understand how these new alternative vehicles work and what to expect before placing a trade. First, let's examine what they are not.

Currency ETFs are not money market substitutes. Although most of them pay monthly interest, they can and do fluctuate in value. For example, the CurrencyShares Australian dollar ETF (NYSEArca: FXA) suffered a decline from a high of $98.84 on July 15 to $87.89 at midday on Tuesday. That represents a decline of 11% in about a month. The fund has still produced substantial returns since its June 2006 inception price of around $73.40. All the while, the fund has kicked out a monthly yield of over 6%.

Note that none of this data resembles a money market in the least.

Another thing currency ETFs are not is a bond substitute. Bonds have a fixed end date where an investor should expect a return of principal. Currencies, on the other hand, can decline for years and possibly never get back to the original starting point. For example, the U.S. dollar peaked in mid-2001 and declined in value over 41% before showing some slight signs of recovery in 2008. The dollar must increase 71% in order to get back to the old high, which could take decades to accomplish if it ever does.

Therefore, currencies are not something that investors can buy and hold for the long term with any degree of certainty.

Finally, currencies are not similar to stocks. The market is immense; in fact, currencies represent all of the money in the world in theory and trade 24 hours a day. Currency traders have many reasons to trade, not all of which involve the desire to make money. Some of the largest players are multinational corporations and even governments of countries seeking to hedge risk.

A simple example is the Toronto Blue Jays baseball team. Most of the players are from the U.S. and desire to be paid in dollars. However, much of the team revenue is based in Canadian dollars, thus the organization might decide to take steps to hedge the risk of currency fluctuations in order to have a more predictable income stream throughout the year.

Investors in stocks, on the other hand, generally have the sole goal of making money. Day traders, hedge funds, and other skittish traders can cause wild swings from day to day and make it difficult to estimate behavior of the market even with the best of research.

What Currency ETFs are is simple: They represent a relationship between two currencies, usually the U.S. dollar and some other currency. For example, if the previously mentioned Australian dollar ETF goes up in value by 1%, that means the value of the U.S. dollar declined by 1% on a relative basis. Each of these relationships move around based on an almost unlimited number of factors, such as political climate, economic activity, interest rates and GDP activity. The interest rate of each currency ETF is similar to money market rates currently being offered in that country. The total return is the interest rate plus the capital appreciation or depreciation versus the U.S. dollar.

Currently, there are many currency ETFs available from CurrencyShares (Rydex), WisdomTree, Market Vectors, ELEMENTS and PowerShares. These range from the popular euro to the more obscure emerging market currencies, such as the Chinese renminbi and the Indian rupee.

Also, it is important to be aware of the market for each ETF. For example, when our currency modeling work indicates a trade, we are careful to execute at the most advantageous price relative to the bid/ask spread and Intraday Indicative Value. Failure to do so can have a severe impact on overall performance.

As the U.S. stock market becomes increasingly subject to the whims of computer-generated algorithms instead of real fundamentals, investors would be well served to become familiar with alternative asset strategies to accomplish their goals.

Anthony Welch is a portfolio manager and co-founder of Sarasota Capital Strategies in Osprey, Fla. The ETF strategist is a regular contributor to IndexUniverse. He can be reached at: