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

Apr.30.10 | About: WisdomTree Japan (DXJ)

By John Gabriel

The case for currencies as an asset class is a debate that has been gaining more and more (pardon the pun) currency these days. In 2009, currency exchange-traded funds saw inflows of roughly $3.7 billion, not bad considering that as of the end of March there was about $6.2 billion invested across 28 currency funds.

This is yet another example of ETFs democratizing an asset class that was previously difficult or impractical for retail investors to gain access to. However, just because these tools are readily available to everyone (thanks to their exchange-traded nature) doesn't mean they're appropriate.

Before rushing to purchase a currency ETF or ETN, it would be 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 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 (NYSEARCA:DXJ) and WisdomTree International Hedged Equity (NYSEARCA: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, etc.).

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 [MABFX].

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.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (NYSEMKT: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.