Currency ETFs Not Just One-Trick Ponies

January 28, 2009

Currency ETFs are a different asset class than money markets and bond funds. But they also can cut portfolio risks when paired with foreign stocks.

 

Exchange-traded funds and exchange-traded notes have opened the doors to the average investor by making currency investing cost-effective and as easy as stock trading.

The usefulness of currency ETFs, however, may be more than as just a different sort of long-term asset class or as tactical tools to build a rotating portfolio.

Consider that research is increasingly pointing to relatively attractive long-term growth prospects in emerging and non-U.S. developed markets.

As investors slowly shift more assets to these foreign markets, the need to lessen the effect of currency fluctuations may become more necessary within diversified portfolios.

Sizing Up The Field

A pair of broad-based currency ETFs from PowerShares may offer a way to lessen the effect of currency fluctuations, the DB US Dollar Index Bullish (NYSE: UUP) and the DB US Dollar Bearish Index (NYSE: UDN).

The two indexes track the same index, the Deutsche Bank US Dollar Index. The Bullish UUP holds a long position of the index, while the Bearish UDN holds short positions in the underlying futures contracts that make up the index.

As the dollar rises against many other developed nations' currencies, in general the Bullish Dollar Fund will rise. When investors are holding a broad range of foreign stocks through broad-based ETFs like the iShares MSCI EAFE Index (NYSE: EFA), their portfolio values are negatively affected by these increases in the value of the dollar against the foreign countries they are invested in.

UUP rises when the value of a broad-based fund such as EFA is negatively impacted by currency exchange fluctuations. As such, used correctly, an investor may be able to offset the negative effect of the currency exchange with UUP.

 

Currencies Hedged By UUP

Percentages

Euro

57.6%

Japanese yen

13.6%

British pound

11.9%

Canadian dollar

9.1%

Swedish krona

4.2%

Swiss franc

3.6%

 

 

Any foreign asset's return gives the investor the return of the currency exchange plus the price return of the asset. The graph below shows the currency exchange return from holding the foreign assets within the MSCI EAFE Index as a U.S. investor using annual returns.

 

Excess Return from Currency Fluctuations EAFE Index USD - EAFE Index Local Currency

 

The International Monetary Fund (IMF), in its World Economic Outlook Update issued Nov. 6, 2008, projects the output for 2009 in developed markets to be -0.3% relative to 2.2% growth in output for the world. The regions expecting the highest growth in output among developed economies are the most newly industrialized Asian countries.

They project that the output for emerging and frontier markets will increase 5.1%. Putting this in perspective, the U.S. and Europe are projected to decrease output by .7% and .5%, respectively, in 2009, compared to 2008; this is to say that outside the U.S., there are significant opportunities for growth. One thing that cannot be overlooked, as U.S. investors invest abroad, is the effect of currency exchange.

In the past, favorable currency exchanges have driven huge excess returns for the U.S. investor. Matt Hougan writes about this affect in his blog. The return on any foreign asset is equal to the price return plus any fluctuations from currency exchanges. The exchange of the U.S. dollar to buy foreign assets through ETFs at times can be significant, as can be seen from the spread between the MSCI EAFE Index denominated in U.S. dollars compared to the local currency.

Through UUP, investors can realize the return from a negative currency exchange, and in general, minimize the effects of increased volatility for the currency exchanges in their ETFs holding foreign assets. As was shown above, returns as reported can differ widely from the actual experience of an investor. Of course, in the past, the U.S. investor has been very happy with the depreciating dollar against the foreign currencies in the MSCI EAFE Index. However, currency movements are hard to predict, and all investors should analyze if offsetting the currency risk in their portfolios is important or needed.

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