With big swings in equity and bond prices becoming the norm, many investors have turned to alternatives to help smooth-out their rides. Realizing that a standard portfolio may not be enough to make to it the finish line, many have taking a page out of institutional investors' playbooks. Asset classes such as commodities and managed futures are creeping into more and more portfolios.
Yet, the world of currency trading or foreign exchange (FOREX) remains absent from many investor’s assets. That’s a shame as the asset class can provide a whole host of benefits.
However, with the boom in exchange traded funds (ETFs), regular retail investors now have the ability to add a dose of currency and its benefits to a long term portfolio.
Focusing On Forex
The currency sector remains the world's largest marketplace, trading trillions of dollars, 24 hours a day. Aside from a few traders opening margin accounts at a forex brokerage like FXCM (NASDAQ: FXCM), many retail investors exposure to the asset class has been limited. It's no wonder. The rapid-fire currency trading environment causes nearly 90% of individual investors to lose money. However, the exchange-traded fund boom has allowed investors to take advantage of the potential in currencies without much of that fast-pace margin trading risk.
And there is plenty of potential.
First, by investing in various notes, investors can increase their overall diversification. Currencies have low correlations versus more traditional securities. They provide the zig when domestic stocks, bonds and other money market instruments zag. According to research by investment manager Merk, a basket of foreign currencies would only have a 0.31 correlation to the S&P 500 and a negative 0.03 correlation o U.S. Treasury bonds. That low correlation even extends itself to other “alternatives” like gold or real estate.
SEE: Alternative Assets For Average Investors
Secondly, an allocation to currency also offers investors the ability to potentially reduce or eliminate certain undesired portfolio risk or provide additional return. If an investor holds too many international stocks, appreciating or deprecating currency values can hurt or boost returns. Adding a swath of forex via an ETF can smooth that ride.
Finally, currency itself can be a source of good returns. Since the end of 1989 through 2012, the Federal Reserve Major Currencies Index- which measures the strength of the U.S. dollar against a trade weighted basket of currencies- produced a 5.19% annual return. That actually bested developed market international stocks as well as a basket of commodity futures by more than a full percentage point.
Adding Some Exposure
There are now 28 different currency exchange traded funds on the market. For example, CurrencyShares Euro Trust (NYSE:FXE) can be used to make a direct bet on a rising euro versus the U.S. dollar, while the WisdomTree Brazilian Real (NYSE:BZF) can be used to bet on the Latin American nation. However, for most retail investors, broader is better.
SEE: Get Exposure And Diversification With A Currency ETF
A good starting place is the actively managed PIMCO Foreign Currency Strategy ETF (NASDAQ:FORX). The relatively new fund- launched in February of 2013- currently tracks 45 different currency holdings against the U.S. dollar. That means it’ll do well if the greenback depreciates. The ETF’s objective is to maximize total returns, meaning that the fund better suited as a long-term investment vehicle than individual currency ETFs that simply mimic a currency’s movement. Expenses run a relatively cheap 0.65%.
With the variance of interest rates around the world, investors can profit by using a carry trade strategy. Essentially, an investor borrows money in a low-interest-rate currency and then invests the proceeds into higher yielding notes. Both the iPath Optimized Currency Carry ETN (NYSE:ICI) and PowerShares DB G10 Currency Harvest (NYSE:DBV) go long and short a basket of currencies from developed nations to profit from the spreads in interest rates. They both make it easy to add currency arbitrage to portfolio.
The Bottom Line
For investors looking for alternatives for their portfolios, currency remains a compelling addition. The exchange-traded fund boom has made it easy for regular retail investors to add currencies such as the Japanese Yen (NYSE:FXY) to a portfolio. Those who do, will be greatly rewarded with a host of diversification and return benefits.
Disclosure: At the time of writing, the author did not own shares of any company mentioned in this article.