Diversify Your Portfolio With Currency ETFs

By Investopedia Staff | May 30, 2012 AAA

The stock market has been volatile, and a large number of investors are looking for ways to move out of equities because they cannot take the ups and downs. It isn't easy to mitigate the volatility, but there is a way to lower the overall beta of a portfolio by adding alternative asset classes such as currencies.

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The world of currencies often referred to as the FX market is the largest and most liquid market in the world. Most investors overlook the opportunities due to lack of knowledge about how to trade currencies and their benefits to diversification. However, since most major currencies can now be accessed through exchange-traded funds (ETFs), the world of FX trading is now open to everyone.

SEE: Top 10 Forex Trading Rules

The Greenback
The U.S. dollar is typically the currency used to base the movement of other foreign currencies. For example the euro will be priced versus the U.S. dollar when quoted on the major financial websites and media outlets. The U.S. Dollar Index, which tracks the price of the greenback versus a basket of foreign currencies, broke a nearly decade long downtrend in early 2008 and has since been extremely volatile.

There are two main ETFs that allow investors to play the U.S. Dollar Index to the upside and downside. The PowerShares DB US Dollar Index Bullish ETF (ARCA:UUP) will move with the index. The PowerShares DB US Dollar Bearish ETF (ARCA:UDN) moves in the opposite direction of the index. For example if the U.S. Dollar Index falls by 10%, ideally UDN will rise 10%.

Euro, Yen and Pound
The euro recently took a major hit, falling aprox.15% in the first quarter of 2012 before now attempting a rally. The euro is trading at one of the lowest levels seen in years, and over 25% lower than the all-time high in 2008. The Rydex CurrencyShares Euro ETF (NYSE:FXE) tracks the euro versus the U.S. dollar and if you were lucky enough to be short the euro this year it was a great hedge against stock market weakness.

SEE: The Currency Market Information Edge

One of the best hedges for a weak US stock market has been the Japanese Yen, which can be tracked for investors through the Rydex CurrencyShares Japanese Yen ETF (ARCA:FXY). After hitting a high in 2010, the S&P 500 has fallen 11% and during the same timeframe FXY has gained 9%. A significant 20% differential in less than four months. Recently though, FXY fell almost 10% in the beginning of 2012, and has started to pull back up towards its all-time high.

A currency that has been out of favor for quite some time is the British pound, accessible through the Rydex CurrencyShares British Pound Sterling ETF (ARCA:FXB). The ETF began to fall in late 2007 and was not able to put together a sustainable rally off the lows, falling over 30% from 2008 to 2009. However, it picked up with the recent, and may be one to watch.

Emerging Market Currencies
The introduction of emerging market currency ETFs has brought on more investment opportunities, but they have yet to catch on. Investors have access to the Brazilian real, Chinese yuan and the Indian rupee to name a few. My suggestion to play this space is the Wisdom Tree Emerging Currency ETF (ARCA:CEW) that invests in a basket of emerging market currencies including the yuan, rupee, real, Chilean peso, and South Korean won to name a few. In all, the ETF invests in 11 emerging currencies.

SEE: Forex Currencies: Emerging Market Currencies

Diversification Made Easy
The introduction of currency ETFs have allowed the average investor the ability to diversify his/her portfolio well away from equities without having to open an FX account. Along with diversification, the currency ETFs also could help hedge against a market sell-off and even make money in tough economic times.

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