Currency ETFs vs. Mutual Funds: Which is Preferable?

Roger Nusbaum submits: A reader asks:

Regarding currency allocation, is there a mutual fund(s) that are worth strong consideration that focus on currency as an allocation class? Why not let a professional manager choose the country?

This is a good question. There are quite a few Open Ended Mutual Funds [OEFs] that are currency funds. I use one for clients from PIMCO. There are a couple of others; one from Franklin, there is the Merck Hard Currency Fund and I believe Prudent, as in the Prudent Bear Fund, may have a currency fund (not positive on that). There must be others.

Both the ETFs and the OEFs have pluses and minuses that investors need to weigh for themselves. The currency ETFs allow investors to capture narrow themes. If you buy into Switzerland as safe haven (which I do but it has not really worked in the last few days), then the Swiss currency ETF (FXF) allows for unfettered exposure to the effect.

Other than the Mexican peso (FXM), I think there is a fundamental case to be made for all of the currency ETFs. I'm not saying you should buy any of them just that there are some compelling points.

If an investor comes to the conclusion that they should own the British pound, they may get it in an actively managed fund that owns the pound for now but what's to say the manager won't change his mind in two months?

The upside of the OEF is that the manager knows what he is doing and the fund is very successful. The down side of the ETF is that the do-it-yourselfer does not know what he is doing.

I think this boils down to philosophy but keep in mind that some of my clients have exposure to both. As another example, a reason to buy the Aussie (personal holding) might be its long-term correlation to gold. There is diversification benefit to this for US based investors. It may not be ideal, in this context, to buy an OEF that might stray away from the Aussie, again assumes the investor is going for a narrow effect.

If the Aussie perpetually zigs when the US zags, it is doing its job as a diversifier even if it goes down.

As a quick note about the Aussie and gold, Bloomberg often notes in articles about Australia that the Aussie has a correlation of about 0.93 (on a scale of 1) to gold. David Taylor questioned this and while I don't know for sure, FXA in its very short life thus far has a 0.64 correlation to the GLD trust (client holding) according to PortfolioScience.com. I expect the correlation to tighten up some even if it does not get to 0.93.

A question about bid ask spreads came in. This is very far down on my list of things to worry about. The reader notes that the spread for the loonie (FXC) is 10-12 cents. I haven't checked but I'll take his word. Often, but not always, volume can print in the middle with a little patience.

The spread becomes more relevant when trying to make a short term trade. Every post about these funds on this site has been for use as a way to diversify the cash portion of your portfolio. If you are looking for a trade you need to consider how big of an issue this is for you.

See more on:

Euro Currency Trust (FXE)
DB Currency Index Value Fund (DBV)
Australian Dollar Trust (FXA)
British Pound Sterling Trust (FXB)
Canadian Dollar Trust (FXC)
Mexican Peso Trust (FXM)
Swedish Krona Trust (FXS)
Swiss Franc Trust (FXF)