The currency market is one area the individual investor often stays away from for several reasons. For starters, the currency market is not widely popular and most investors do not understand the dynamics behind currencies. There is also the complexity of setting up a futures account that is separate from the traditional stock portfolio. In the end it equates to lots of effort and time, and for what?
Because it is rare to find a currency that remains in a long-term uptrend, the investment vehicle can be used as an intermediate-term investment. Currencies are capable of moving in a trend for years, but at some point they almost always turnaround. For example, the US Dollar Index has been in a downtrend since hitting a high in early 2002 and will likely find a bottom in the next few years.
Introduction of the Currency ETFs
In 2002 the only way to directly play the falling greenback was to short the U.S. dollar or go long one of its peers. Now there are a number of options for investors in the form of exchange-traded funds (ETFs).
In December 2005, Rydex introduced the CurrencyShares Euro Trust (NYSE: FXE), an ETF that mimics the movement of the euro. Since that time, FXE has been in an uptrend and recently hit a new historic high as the currency continues to rise against the U.S. dollar.
Another wave of currency ETFs were introduced by Rydex in mid-2006. In all, there are now eight Rydex ETFs that cover the following currencies: Australian dollar (NYSE: FXA), British Pound (NYSE: FXB), Canadian dollar (NYSE: FXC), euro (NYSE: FXE), Japanese yen (NYSE:FXY), Mexican peso (NYSE: FXM), Swedish krona (NYSE: FXS), and Swiss franc (NYSE: FXF).
Benefits of Currency ETFs
The beauty of the Rydex ETFs is the ease versus opening a currency account. An investor is able to gain instant exposure to any of the currencies listed by simply following the same procedure as you would for buying a stock.
Suppose you believed the British Pound was undervalued last year at $1.82 and wanted to take advantage of any rise in the currency. You could have purchases shares of FXB at $182 and rode the rally of the Pound up to a 15-year high at $2 or $200 per share. That is a 10% gain in less than a year.
The chance of a currency ETF being the big winner of the portfolio is slim; however, they can be great products to both diversify and/or hedge your portfolio. If the U.S. dollar continues its downtrend it is likely the euro and Australian dollar will continue to rise, offering a hedge against the falling greenback as well as a strategy to profit.
New Currency Products
Two new ETFs were introduced by PowerShares in February that track the U.S. Dollar Index I alluded to earlier in the article. The PowerShares DB US Dollar Index Bullish Fund (AMEX: UUP) will move in line with the index and the PowerShares DB US Dollar Index Bearish Fund (AMEX: UDN) moves in opposition to the index. Therefore, investors that believe the U.S. dollar will turn around and rally should buy UUP and those investors that predict a continued downtrend (me included) can buy UDN. (To learn more, see Uncovering The ETF Wrap.)
Using the PowerShares currency ETFs is a great strategy for investors that want to play the currency market. However, keep in mind the tax treatment is different from that of a normal ETF or stock. Because the ETFs are invested in futures contracts they won't be treated as normal investments, and are taxed at a higher percentage. (Please consult your tax advisor for more information.)
The final currency ETF is the PowerShares DB G10 Currency Harvest Fund (AMEX: DBV). This ETF is unique because it is composed of six of the 10 currencies included in the G10 list. Specifically, the ETF holds long futures contracts on the three currencies with the highest interest rates and short the futures of the three currencies with the lowest interest rate. As of May 16, the ETF is long the New Zealand dollar, Australian dollar, and British Pound. On the short side are the Japanese yen, Swiss franc, and Swedish krona.
What impresses me about DBV is the diversification through a variety of currencies and more importantly its track record. Since 1994, the index it tracks has only had one down year (-1.68% in 1998). The expense ratio is 0.75% and the portfolio is rebalanced every quarter.
There are a number of options for investors wanting to delve into the currency market by the way of ETFs. However, make sure you do your homework before making any decisions. And if you want to take the easy route there is DBV, which will diversify for you and offer a consistent return.
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