Direct Currency Bets
That context is important because it helps investors understand where the dollar is trading historically. It’s not high or low; it’s right around its average level of the past two decades.
With that said, what should an investor to do when it comes to currencies? The most aggressive option—only appropriate for active traders—is to take a directional bet on the dollar.
One predominant view is that the buck will continue to weaken as international economies outperform the U.S. and central banks like the ECB tighten monetary policy fairly aggressively. The opposing view is that the U.S. economy outperforms, with GDP growth handily outpacing 3%, leading to faster inflation, faster Fed rate hikes and a stronger dollar.
Whatever you view, there’s plenty of ETFs available to make those direct currency bets.
In addition to the aforementioned CEW, there’s the PowerShares DB U.S. Dollar Bullish Fund (UUP), which provides inverse exposure to the U.S. Dollar Index; the CurrencyShares Euro Trust (FXE), which targets the euro; the CurrencyShares Japanese Yen Trust (FXY), which goes long the yen, and many more.
Even for investors who aren’t interested in speculating directly on foreign exchange rates, currencies still have an impact. That doesn’t necessarily mean investors have to make dramatic moves to their portfolios in response to fluctuations in currencies, but they should understand how such movements may affect their returns.
For instance, a weaker dollar makes U.S. exporters more competitive and boosts the profits of multinational companies that do a lot of business overseas.
Large-cap stocks, such as those held by the SPDR S&P 500 ETF Trust (SPY), tend to have more exposure to those types of companies than the domestic-focused small-cap stocks of the iShares Russell 2000 ETF (IWM).
Meanwhile, anyone invested in foreign stocks is making at least a tacit bet on currency movements. For example, the returns for a vanilla, unhedged position in German stocks in a U.S. investor’s portfolio will be influenced both by the performance of the underlying equities and the performance of the euro against the U.S. dollar.
Investors can hedge that risk with a plethora of currency-hedged ETFs available on the market, including the WisdomTree Japan Hedged Equity Fund (DXJ), the WisdomTree Europe Hedged Equity Fund (HEDJ), the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) and the iShares Currency Hedged MSCI EAFE ETF (HEFA).
Currency-hedged products tend to outperform their vanilla counterparts when the dollar is climbing (and vice versa).
However, keep in mind that it doesn’t always make sense to hedge currency risk, even when you have a strong view on a particular currency. In some cases, the cost to hedge is prohibitively expensive, such as when hedging currencies with high interest rates (e.g., emerging market currencies).
Follow Sumit Roy on Twitter @sumitroy2