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Does a Currency Bet Make 'Cents'?

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. With the Fed's recent policy measures still clear the rearview mirror, currency issues have seemed to take center stage in lot of headlines.

Meanwhile, ETFs have offered investors a lot of different ways to invest directly in currencies, but just because they can, does it mean that they should?

Here with me to talk about how to think about currencies in a portfolio is Morningstar's Michael Rawson. He is on our ETF team.

Thanks, so much for joining me Mike.

Michael Rawson: Thanks for having me, Jason.

Stipp: Sure. So the first question for you: ETFs have democratized the currency space; they've made it easier for investors to access currencies. How have you seen that play out and broadly, what kinds of products are available for ETF investors in this space?

Rawson: Well, certainly I think a lot of people are familiar with investing personally in stocks. They know how to buy stocks and sell stocks in their own account or a through a broker. However, not as many people are familiar with using futures accounts and people are little bit intimated by that.

What the ETF has allowed is for people to trade currencies without having to go open up a futures account. They can directly trade them just like they would a stock like IBM or Microsoft. They can access currencies through ETFs.

However, there is a number of different ETFs out there, and they themselves have different structures. So, investors should be a little bit aware of the different structures of those currency ETFs before they start investing.

Stipp: We'll talk little bit more about some of those in a bit, but first wanted to ask you, as investors are thinking about currencies and as it seems to be that the dollar going up and down has an effect on the market, what are ways that an investor might employ a currency position?

I think, generally, we think of a strategic portfolio and a tactical portfolio. So, for a strategic or a long-term investment portfolio, should investors think about employing a currency bet explicitly or what should their thought process be about that?

Rawson: Well, that's really a kind of a personal decision about how many assets they want to invest in. If they want to keep their portfolio simple, stocks and bonds, and limited it to that, they don't necessarily need to invest in currencies.

However, for someone who really wants to get as much diversification as possible, there is a little bit of room for a small strategic position in currencies, and currencies are a cash instruments much like short-term bond or a money market instrument. So, it should really be thought of as a small portion to replace an existing holding in a money market fund or a short-term bond fund, but again you want to limit it to a small portion of your portfolio because over the long-term currencies like any other cash instrument is going to have a very low rate of return, it probably won't even keep up with inflation. But it does have some diversification benefits in that, it has very low volatility and will benefit if the market were to crater, you'll have access to cash, which is always a good thing.

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Stipp: Is there any specific kind of a strategic portfolio where it might make more sense for an explicit currency bet? So, if I have overseas holdings already, I kind of have an exposure to currency anyway. So, if there is certain kind of portfolio where it might make more sense for me to go and look at the currency ETF?

Rawson: Well, certainly, I mean you mentioned that investors may already have currency exposure without even realizing it. Certainly, our S&P 500 companies are multinational companies. They benefit from a strong foreign currency if they are translating those profits backs to U.S. dollars. So, most investors already have some exposure internationally and to foreign currencies.

However, if there is a certain type of investor which may benefit more from having a foreign currency ETF. People that have a large anticipated expense in a foreign currency, let's say they are planning a lifetime dream vacation to Europe, and they are concerned about the cost of that going up, or maybe they are going to send a child off to college in a foreign country, they may want to lock in some of that cost today using hedging with the currency ETF.

So, there are some opportunities where you can even lower your risk even more for a strategic investor through hedging. That's somewhat rare, though, not many of us are fortunate enough to have that sort of need.

Stipp: Sure. Looking at the tactical side: We've obviously read a lot about the dollar, and the future of the dollar, and the Fed is stimulating the economy with more purchases, which maybe have a downward pressure on the dollar longer term. It seems like there could be some tactical opportunities to invest, to try to get some extra return, if you do think, for example, that dollar is going to go down. How should you think, if you are a tactical investor, what ideas might be out there for how you could invest and maybe capitalize on that?

Rawson: Absolutely. For a tactical investor who wants to be little bit more aggressive and maybe does their own homework and has their own investment thesis, there are number of ways to invest in ETFs to get foreign currency exposure and there are a number of good fundamental reasons why they might want to do so.

You mentioned the Fed engaging in quantitative easing; what that is going to do is, it's going to lower the value of the U.S dollar abroad, and it's going to force up prices of commodity such as oil or food, and we're already starting to see that, because these commodities are traded internationally. It's not just a local market. There is demand from foreign buyers, so that's going to force up those prices in U.S dollar terms.

So, tactically, for an aggressive investor who may want exposure to foreign currency ETFs, I think there is a good fundamental case for dollar weakening in the future.

Stipp: And you also – the Morningstar ETFInvestor newsletter team – you had a tactical position there that you took. Can you explain a little bit about what's behind that?

Rawson: Sure, just to preface it--we run two portfolios in the ETF group: a tactical more aggressive hands-on portfolio, and a strategic kind of set-it and forget-it portfolio. In that strategic portfolio, where we don't encourage a lot of risk-taking, we don't hold on any foreign currency positions, but in our tactical portfolio we have chosen to try to ride this tide of emerging market currency appreciation through a local market foreign currency bond fund. It's run by WisdomTree. Its call the WisdomTree Emerging Markets Local Debt Fund, and symbols there is ELD.

What that does is, it goes out and buys foreign bonds of emerging markets countries, sovereign bonds, so that they have good credit risk, but it's denominated in foreign currencies. So, we get the exposure to the bond market and also to the foreign currencies, and we are hoping that those foreign currencies appreciate. One thing we like about this product is that it actually goes out and buys those foreign bonds. It doesn't get the exposure through swaps or through buying U.S dollar denominated emerging market bonds.

Stipp: So, this bet in that portfolio is still relatively small position. All the factors that go into how currencies move up and down, it's very hard, especially in the short term, to kind of determine that, so you have limited somewhat because of the uncertainty perhaps?

Rawson: Yes, it's only a 5% position. We only have about 10 or 12 positions in that portfolio. So it's one of our smaller holdings. As you mentioned, it's very difficult to forecast currency movements. Certainly in the very short term, it's a random walk, and even over longer time periods, economists don't have a firm grasp of why currencies appreciate or depreciate.

There are two factors though that we can look at, which kind of lead us into the conclusion that well perhaps the dollar is going to continue to weaken.

First of all one of the determinants of the value of a currency is the amount of money out there circulating in the economy. You've got the Fed, as you mentioned quantitative easing, essentially printing money--that's going to increase the supply of dollars and lower their value in the United States. The second determinant of the value of the currency is the growth of the underlying economy that backs that currency, and compared to emerging markets, the U.S is probably going to have a little bit slower growth. So, we think there is a strong fundamental case, despite the fact that we realize currency speculation is risky.

Stipp: You had mentioned a little bit before about why you like the structure of the fund that you chose there, and there are different structures in how currency ETFs are put together. Can you talk a little bit about what investors should have on their radars as they are comparing these options?

Rawson: One of the simplest structures is provided by an ETF group called CurrencyShares, this is run by Rydex. CurrencyShares for example they have a CurrencyShares Euro Trust, the symbol there is FXE. What that does is, it goes out and buys foreign currencies, puts them in a foreign bank account, and it sits there in a deposit account earning interest. So, it's a very safe approach, very straightforward, and investors will get a 1099 statement in an income tax form,

But one of the things we don't like about this particular ETF is that it's a single currency ETF. When you are placing a bet on the euro, you are implicitly placing a short bet against the dollar. Well you may have a view that the dollar is going to weaken, but now you also have to take a view on the euro. So, another way around that would be to buy a currency ETF which invests in a basket of currencies, such as the PowerShares Dollar Bearish Fund, which goes short the dollar and goes long a basket of currencies, primarily developed market currencies such as the euro, the yen, and the U.K pound.

However, even though we like the investment basket that this ETF invests in, we have some hesitation about the structure. It's a little bit more complex in that it's a partnership which invests in futures. It tracks the futures index. What that means is, you are going to get a K-1 when it comes time to file your taxes, which is a little bit more complex than a 1099, and it's taxed at a 60-40 split long-term short-term rate. So, that adds a little bit of a complexity to the choice despite that fact that we like the diversified basket approach that it follows.

Stipp: Mike, thanks so much for your insights in the different ETF products, also your fundamental take on the dollar and for joining me today.

Rawson: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.