Diversify with Currency

By Aaron Levitt | May 20, 2009 AAA

The global meltdown of 2007 and 2008 has shown that the simple rules of diversification between stocks, bonds and real estate assets may not be enough to weather downside risk. Taking their cues from institutional investors and endowments, retail investors are now choosing some non-traditional assets. The recent exchange-traded fund (ETF) boom has supplied many products and asset classes normally not available to the average investor. Through the Barclays Global Carbon NTS (NYSE: GRN), everything from commodities to carbon credits is now available. While I'm not sure who needs to really participate in the carbon credit market, there are other opportunities for alternative asset classes using ETFs. (For more, see An Inside Look At ETF Construction.)

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Focusing on Currency

While currencies typically aren't used as long-term growth vehicles like stocks are, they can provide many benefits to an overall portfolio. By investing in various notes, investors can increase their diversification. These types of assets have low correlations versus more traditional securities. Currencies often move independently of domestic stock, bonds and other money market investments. Looking over a 10 year period (April 1, 1999 - March 30, 2008), currencies provided correlations of 0.68, 0.20 and -0.02, respectively. In addition, they exhibit low parallels compared to other "alternative" asset classes such as commodities and gold.

Currencies also allow investors to benefit from the declining U.S. dollar. The current financial maelstrom has left many investors reaching for safety and the dollar has regained some strength as the fiat currency of choice. However, recent events aside, over the last 10 years the greenback has lost about 4.6% of value versus its major trading partners. In the global economy, investors, while increasing the value of their assets, can still lose ground long-term with the declining dollar.

Currencies can also give retail investors higher yield exposure. Money market rates in South Africa are very different than those in Switzerland. Currently, that difference stands at about 9%. Underlying economic factors and worldwide confidence in monetary policy have a direct effect on these rates. Investors willing to take on added risk can be handsomely rewarded. (For more, see Forex: Wading Into The Currency Market.)

A Few ETF Picks
Currency exchange-traded funds come in a variety of forms, each with its own advantages, disadvantages, tax considerations and uses. Investors should do their own rigorous research before jumping into any of these funds.

In terms of a broad basket of currencies, there are two funds on the market. The oldest being the PowerShares DB G10 Currency Harvest Fund (NYSE: DBV). The fund owns currency future contracts on certain G10 countries notes. These include U.S. dollars, euros, yen, and pounds. The index is optimized to produce a "carry-trade" transaction, going long with the notes with higher interest rates and shortening those with the lowest. Over a 10 year period ending in 2008, the index, on which the ETF is based, has returned about 8%. In the same time, the S&P 500 has produced a negative annualized return of 1.38%. Remember, the ETF is not a mutual fund and does not fall under the Investment Company Act of 1940. It is set up as a limited partnership and investors will see a K-1 statement come tax time. Currency Harvest charges 0.75% in annual management expenses plus 0.06% in futures brokerage expenses. (See our related article, Forex Leverage: A Double-Edged Sword.)

The second and most recent (launched about two weeks ago) is the WisdomTree Dreyfus Emerging Currency Fund (NYSE: CEW). While the PowerShares fund focuses on heavily traded industrial nations, the WisdomTree ETF will focus on emerging and developing countries. This allows investors to participate in currencies such as the Israeli shekel, Polish zloty, Chilean peso and Indian rupee. The Emerging Currency Fund follows an interesting structure in order to complete its objective. Using high-quality U.S. money market investments, and forward currency swaps and contracts, it achieves a risk-return exposure that is economically similar to money market instruments denominated in the specified emerging currencies. WisdomTree sponsors similar single currency funds that use this strategy including the WisdomTree Dreyfus Chinese Yuan (NYSE: CYB) and WisdomTree Dreyfus Euro (NYSE: EU), currently the only way to participate in China's currencies. The fund plans on making annual distributions, and expenses run 0.55%.

Just as the iShares Silver Trust (NYSE: SLV) holds real bars of silver in a vault, the Rydex family of CurrencyShares hold real notes locked up in vault. Each share of the fund represents 100 notes of each currency and pays a monthly interest distribution. The largest and most actively traded of the Rydex funds is that of the CurrencyShares Euro Trust (NYSE: FXE). This ETF allows investors to participate in the currency of 16 countries making up the European Union, which is the second-most traded currency worldwide, accounting for 37% of all currency transactions. The fund currently yields 3% and charges 0.40% in annual expenses. (For more currency trading, see our Forex Tutorial: Introduction to Currency Trading.)

Bottom Line
As investors look towards creating broader portfolios in order to cover downside risk, they are choosing more non-traditional asset classes. Currencies can fill a void in any portfolio and provide many diversification benefits. There are many exchange products in this area and these ETFs are a good place to begin an investigation. (To learn more about currency ETFs, see Advantages Of Exchange-Traded Funds and Profit From Forex With Currency ETFs.)

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