by Ken Hawkins

Although fixed income and equity investments are the core of a diversified portfolio, the use of alternative asset classes can provide additional diversification. These alternative investments can also be used for trading or hedging existing positions. There are a number of different ETFs that allow investors to establish positions in currencies or commodities. Also, with the use of inverse ETFs, an investor can bet that the market will decline. (For related reading, see Inverse ETFs Can Life A Falling Portfolio.)

Currency ETFs
Currency ETFs are designed to track the movement of a currency in the exchange market. The underlying investments in a currency ETF will be either foreign cash deposits or futures contracts. ETFs based on futures will invest the excess cash in high-quality bonds, typically U.S.Treasury bonds. The management fee is deducted from the interest earned on the bonds. (To learn more, read Profit From Forex With Currency ETFs and Currency ETFs Simplify Forex Trades.)

Several choices of currency ETFs are available in the marketplace. An investor can purchase ETFs that track individual currencies such as the Swiss franc, the euro, the Japanese yen or a basket of currencies. However, currency ETFs should not be considered a long-term investment; investors who are looking to diversify their U.S. dollar assets are generally better off investing in foreign stock or bond ETFs. However, currency ETFs can help investors to hedge their exposure to foreign currencies.

Examples of currency ETFs include:
  • PowerShares DB U.S. Dollar Bullish Fund (AMEX:UUP)
  • PowerShares DB U.S. Dollar Bearish Fund (AMEX:UDN)

Commodity ETFs
Commodities are a separate asset class from stocks and bonds, so investing in commodity ETFs can provide extra diversification in a portfolio. Because they are hard assets, these ETFs can also provide protection against unexpected inflation. (For more insight, read Commodities: The Portfolio Hedge.)

Commodity ETFs can be divided in three types:
  1. ETFs that track an individual commodity like gold, oil, or soybeans
  2. ETFs that track a basket of different commodities
  3. ETFs that invest in a group of companies that produce a commodity

Commodity ETFs either hold the actual commodity or purchase futures contracts. ETFs that use futures contracts have uninvested cash, which is used to purchase interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.

Examples of commodity ETFs include:
  • iShares GSCI Commodity-Indexed Trust ETF (PSE:GSG)
  • PowerShares DB Commodity Index Tracking Fund ETF (PSE:DBC)

Inverse ETFs and Leveraged Inverse ETFs
With the advent of inverse ETFs, investors can easily bet against the market. Inverse ETFs are designed to move in the opposite direction of their benchmarks. For example, if the S&P 500 rises by 1%, the inverse S&P 500 ETF should drop by 1% and vice versa. There are also leveraged inverse ETFs, which are designed to provide double the opposite performance of the underlying index, so, if the S&P 500 drops by 1%, a leveraged inverse S&P 500 ETF should increase by 2%. (For related reading, see Dissecting Leveraged ETF Returns and Rebound Quickly With Leveraged ETFs.)

An inverse ETF can either use short positions of the underlying stocks or futures. ETFs that use futures contracts can have the excess cash invested in bonds, which covers the expenses of the ETF and can pay dividends to the owners.

There are a number of reasons to use inverse ETFs. For example, while speculators can easily make a bearish bet on the market, for investors who have positions that they do not want to sell because of unrealized capital gains or illiquidity, this is not so easy. In this case, they can buy an inverse ETF as a hedge.

In fact, many investors prefer to use inverse ETFs instead of selling short the index. Inverse ETFs can be purchased in tax-deferred accounts, but shorting stocks is not allowed because in theory, it exposes the investor to unlimited losses. However, the most an investor in an inverse ETF can lose is the entire value of the inverse ETF.

Examples of inverse ETF include:
  • ProShares Short QQQ ETF (AMEX:PSQ)
  • ProShares Short S&P500 ETF (AMEX:SH)

Examples of leveraged inverse ETFs include:
  • ProShares UltraShort QQQ ETF (AMEX:QID)
  • ProShares UltraShort S&P500 ETF (AMEX:SDS)

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