You Don't Need Currency ETFs to Bet on Exchange Rates

The case for currencies as an asset class is a debate that has been gaining more and more (pardon the pun) currency. After attracting inflows of roughly $3.2 billion in the fourth quarter of 2009, asset flows into currency exchange-traded funds cooled off considerably in the first half of this year. That is, until the Federal Reserve's recently announced second quantitative easing program sparked concerns of global currency wars. Through the first nine months of the year, currency ETFs and exchange-traded notes saw net outflows totaling nearly $2.5 billion, but investors poured more than $119 million into the group in October. As of Nov. 15, 2010, there was about $5.3 billion invested across 32 currency funds.

The proliferation of currency ETFs is yet another example of ETFs democratizing an asset class in which its accessibility was previously difficult or impractical for retail investors. However, just because these tools are readily available to everyone (as a result of their exchange-traded nature) doesn't mean they're necessarily appropriate for all.

Before rushing to purchase a currency ETF or ETN, it's useful to evaluate the implicit currency bets that might already be lurking inside your portfolio. U.S.-based investors who own non-U.S. assets most likely already have sizable exposure to foreign currencies. Remember, the total return of foreign assets for U.S. investors is composed of two parts: its local price return and the currency's change relative to the greenback over the investment period. As international stock and bond allocations make up bigger and bigger slices of many investors' portfolios, it becomes increasingly important to recognize and understand the impact that currency exposure can have on your portfolio's risks and returns.

Consider a few examples. In local currency terms, the MSCI Australia Index returned roughly 32% from the start of 2009 through mid-April, but in U.S. dollar terms the return was well over 70%. Over the same period, we saw similar cases with Brazil and Canada. The local returns for the MSCI Brazil Index and the MSCI Canada Index were about 54% and 31%, respectively. In U.S. dollars, however, Brazil more than doubled and the Canadian index enjoyed a return of approximately 60%.

By the same token, a strengthening U.S. dollar relative to a foreign currency would be a drag on the total return of unhedged international stocks. We saw this back in 2005 when the greenback was strengthening against most other currencies. For instance, the local market return for the MSCI UK Index in 2005 was 20.1%--not too shabby. But the pound sterling lost nearly 13% of its value against the U.S. dollar, leaving U.S.-based investors with a total return of 7.4%. Similarly, the local currency MSCI Japan Index rose 44.6% in 2005, but because the yen lost roughly 19.1% relative to the greenback over the same period, U.S. investors enjoyed a return of "only" 25.5%.

As the above examples illustrate, it can be critically important to understand the source of your investment returns. Again, this is not to say that investors should consider plowing into currency ETFs or opening a 24-hour forex trading account (we've all seen the commercials). Rather, simply knowing the source of our total returns can be helpful information when rebalancing our portfolios or tweaking our tactical bets.

To help investors isolate local market returns, some ETF providers are rolling out international products that include embedded currency hedges. The newest funds include  WisdomTree Japan Hedged Equity (DXJ) and WisdomTree International Hedged Equity (HEDJ). Such products would be appropriate for those looking to avoid the added volatility that movements in foreign exchange rates can have on international investments. They also help investors limit their total outlay and avoid the added transaction costs from managing their own hedges via additional currency instruments.

While the currency market is the largest and most liquid market in the world, with more than $3 trillion trading per day on average, studies show that it remains less efficient than other asset classes. This is due to the participation of several non-profit-seeking players in the market (that is, corporate treasurers, central banks, tourists, and so on).

Even still, with so many factors simultaneously influencing currency movements, identifying inefficiencies and profiting from them can prove extremely elusive. Furthermore, there's no telling how long a currency might deviate from its underlying fundamental value. Considering the difficulties inherent in currency investing, tactical investors looking to take advantage of such inefficiencies may wish to solicit the expertise of professional money managers such as Axel Merk, who runs Merk Absolute Return Currency .

Moreover, we should note that currencies are a zero-sum game--as opposed to stocks or bonds, there is no positive expected return above the risk-free rate in currencies over the long term. (See Bradley Kay's article, "Nobody Ever Got Rich Holding Cash.") Exchange rates measure the relative values between currencies. Hence, theoretically, the respective values of every currency cannot all increase over the same time frame--one currency's appreciation will equal the corresponding aggregate depreciation in other currencies.

A version of this article appeared April 28, 2010.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Don't Miss Morningstar's ETF Webcasts, Dec. 14, on BrightTALK

Generating Income with ETFs and Shielding from Inflation
with Paul Justice, Associate Director of ETF Research for Morningstar
This presentation will give an overview of the current state of the markets and how ETFs can be used for income generation and to reduce the impact of inflation. Paul will also discuss the unique features of some ETFs commonly used for those purposes.

Building a Strategic Portfolio with ETFs
with Michael Rawson, ETF Analyst, Morningstar
This presentation will give an introduction to ETFs and describe how they can be used to build a strategic asset allocation.

Click here to register.

Also presenting:

Industry Trends and Using ETFs to Implement Asset Allocation
Deborah Fuhr, Global Head of ETF Research & Implementation Strategy, BlackRock

You will be able to attend any or all of the presentations in this complimentary summit, submit real-time questions to presenters and vote in audience polls during the live webcasts. If you are unable to attend the webcasts live, you can also view them afterward on demand.