With the broad stock market continuing to hit new highs despite worries of a correction, investors have been getting a tad worried. That has them looking towards various alternative asset classes to help stem the volatility and diversify their portfolios. Everything from long/short strategies to commodities have become common holdings for investors. (For more, see: Alternative Assets For Average Investors.)
However, one alternative asset classes remains absent from many investor’s assets. Currency trading or foreign exchange (Forex) shouldn’t be ignored by retail investors, especially now that there are a host of products that allow Regular Joes access to the once-guarded realm, such as exchange traded funds (ETFs). (For more, see: Forex Tutorial: Introduction To Currency Trading.)
Why Add Currency?
Despite the fact that currency foreign exchange is the world’s largest marketplace (it trades trillions of dollars 24 hours a day), retail investors have had limited exposure to the asset class. There's a good reason for that; the rapid-fire currency trading environment conjures visions of traders hopped-up on Red Bull and cheap margin accounts, only lose their shirts with a single trade. After all, nearly 90% of individual investors lose money when trading Forex. (For more, see: Forex: Finding Your Trading Style.)
Yet, the asset class still provides plenty of portfolio benefits for those investors willing to take the plunge. Just focus on some of the ETFs.
First, currency offers plenty of diversification benefits and represents a true uncorrelated asset class. That helps reduce or eliminate certain undesired portfolio risks. According to research by investment manager Merk Funds, a basket of foreign currencies would only have a 0.45 correlation to the S&P 500 and a negative 0.04 correlation to U.S. Treasury bonds. Merk’s research also found that a basket of currencies provide those returns with less movement and volatility than stocks or bonds. That throws cold water on the notion that Forex is extremely volatile. (For more, see: Trading Currencies: A Forex Walkthrough.)
In addition, a currency allocation can boost returns. Several currency pairs are tied to the performance of an underlying economy. For example, the Canadian Loonie — as represented by the CurrencyShares Canadian Dollar ETF (FXC) — is very correlated with rising oil and mineral prices. Investors can use this to their benefit and take advantage of developing trends. (For more, see: The Top 6 Most Tradable Currency Pairs.)
That allows investors to actually enhance the return of their international holdings. Japanese stocks are prime example of this fact. Looking at historical returns, the broad Nikkei 225 Index returned nearly 40% back in 2005. However, the uber-popular iShares MSCI Japan (EWJ) only returned 20%. The difference was the value of the yen versus U.S. dollars. Currencies can be used to hedge and enhance equity returns.
Making A Currency Bet
While you could open up a Forex brokerage account at a firm like FXCM Inc. (FXCM) and actually trade currency pairs, the easiest — and perhaps best — way for individual investors to make a currency play is via ETFs. There are now almost 30 different funds that investors can choose from that make adding Euros as easy as placing a trade for the CurrencyShares Euro ETF (FXE).
A great place to start is with the PIMCO Foreign Currency Strategy ETF (FORX). The ETF is actively managed and places its bets on currencies, forwards and other ultra-short term fixed income securities denominated in the currencies of foreign countries. FORX is basically a bet on the depreciation of the U.S. dollar and is managed for long term returns. Expenses run 0.65%. Conversely, the new WisdomTree Bloomberg US Dollar Bullish ETF (USDU) allows investors to be on the strength of the greenback. (For more, see: Profit From Forex With Currency ETFs.)
Another option for investors is to profit from the various interest rates across the world. Called the “carry trade,” an investor will borrow money in a low-interest rate currency and then invests the proceeds in a higher yielding one. The PowerShares DB G10 Currency Harvest ETF (DBV) goes long and short a basket of developed-nation currencies to profit from the spreads in interest rates.
Finally, Asia continues to dominate with its economic prowess. That has translated to stronger currencies for many of its nations. For example, investors can bet the Chinese Yuan and Singapore dollar, respectively, with the WisdomTree Chinese Yuan Strategy ETF (CYB) and the CurrencyShares Singapore Dollar ETF (FXSG). Meanwhile, the iPath GEMS Asia 8 ETN (AYT) tracks a basket of currency from Asia’s eight biggest economies. (For more, see: Currency ETFs Simplify Forex Trades.)
The Bottom Line
Despite being the world’s biggest marketplace, most retail investors have zero exposure to currency. They're missing out on plenty of portfolio benefits, then. The key is using one of the many new ETFs to play it and skip the complications and pitfalls of a Forex account.