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Summary

  • Investors may want to consider reducing equity market exposure pending a possible future correction.
  • Currency ETFs are a low-cost, low-leverage way to make an investment in the currency market.
  • Investing in currencies allows for a hedge against traditional investments and the potential for enhanced returns with less risk.

Background

Market observers have been increasingly cognizant of a potential correction in the future. Specifically, mutual funds have seen 15 straight weeks of outflows, hedge funds are seemingly taking bearish positions, and many equity strategists are recommending going underweight equities. As well, with broad stock market indices hitting new highs on a regular basis, and with valuations coming in at concerning levels, many investors are looking to reduce their exposures to US equity markets. To put this in perspective, it has been two years without a 10% correction, and five years without a 20% drawdown. Whether investors are set to suffer losses in the coming months is up for the market to decide. No one can predict if or when a correction will occur, but the best we can do is diversify our portfolios, and prepare ourselves to handle potential losses.

Where to Invest?

I recommend that investors look to various alternative asset classes to help bolster volatility and to act as a hedge to equity markets. While alternative investments on their own may indeed have higher volatility than traditional investments, particularly fixed income, they typically have lower correlations to traditional asset classes. As such, including alternatives in an investment portfolio tends to result in lower overall portfolio volatility, and consequently a lower risk profile (see below). Before I tell you my recommendation on which alternative investment assets to invest in, let's start by defining alternative investments, and looking at some examples first.

Alternative Investments Defined

Essentially, alternative investments take opposing approaches to traditional equity or fixed income investments. Traditionally, this approach may involve holding both long and short positions, as well as holding private securities instead of listed ones. Such approaches also commonly employ derivatives as a hedging strategy. Given the low correlation to traditional investments, these essentially enhance the risk/return profile by offering the potential for enhanced returns with less risk to the portfolio as a whole (see the below graph).

Examples of Alternative Investments

1) Private Equity

  • This strategy looks to invest in high potential growth companies that are privately owned through long-term investments. Given the illiquid nature of such an investment, investors, commonly high-net worth individuals, can expect better long-term capital appreciation than traditional investments.

2) Hedge Funds

  • These are actively managed portfolios that employ leverage, long/short positions, and derivatives for a higher absolute return. As well, these instruments are typically only available to higher-net-worth individuals as the minimum investments are often quite high.

3) Managed Futures

  • This strategy invests in trends in global future markets. Common futures traded are: currencies, interest rates, stock indexes, energy, and commodities. Most of the strategies in this category employ extensive algorithms and computer programs to exploit both short- and long-term trends in the marketplace. Despite the fact that this is an easy way to reduce the overall correlation to traditional assets, managed futures are commonly criticized for their tax inefficiencies.

4) Alternative Mutual Funds

  • These funds are hard to define as they are not confined to traditional portfolio management styles. They often use a wide array of approaches from long/short equity positions, absolute return, and other hedge-fund like strategies. These portfolios essentially have a "go anywhere" mentality and invest in anything they see fit. This asset class is a strong choice because not only do they provide investors with good liquidity, but they do so at low fee rates (usually).

For the sake of argument, some traditional investments, as opposed to alternatives, would be: Domestic/International Equities, Taxable/Tax-Exempt Fixed Income, Cash, Global Real Estate, High-Yield Debt, and Emerging Market Equities.

Which Alternative Asset Should You Invest In?

Now, I do not recommend starting off by investing in any of the above investments. But, I do recommend that investors diversify and pull some exposure away from equity markets by investing in foreign exchange. However, if you want to get exposure to forex you would traditionally have to trade forex futures, and open up a forex account, and worry about things like margin maintenance and leverage. However, there is another way to get that much needed portfolio diversification through forex: ETFs. The easiest and perhaps the best way to invest in currencies for the individual investor is through ETFs. Now a days, you can get exposure to almost any currency through the use of a simple ETF.

What are Currency ETFs?

Currency ETFs replicate the movements of various currencies by either holding currency cash deposits in that specific currency or using futures contracts to bet on the underlying currency. Whatever the case, the movements of the ETF price and the currency exchange rate have a very high correlated return. As well, these funds typically have lower management fees as there is often little active management involved.

Why Invest in Currency ETFs?

As I touched upon before, currencies offer a strong amount of diversification that will work to eliminate undesired portfolio risks. Specifically, when looking at the correlation between the US Dollar Index (USDX), an index that tracks the value of the U.S. dollar against six other currencies, and the DJIA, S&P 500, and Nasdaq, we see correlation coefficients of .35, .38, and .39, respectively. This means that only 35% of the DJIA's movements are correlated to the movement of the U.S. dollar. As well, only 4% of the movement in U.S. Treasury prices are correlated to movements in the USDX.

Secondly, allocation to currencies can enhance the returns from the underlying economy. For example, the Japanese Yen, has a historical correlation to oil prices. Since Japan imports almost 50% of its oil and requires large amounts of it, the Japanese economy is very susceptible to changes in oil prices. Therefore, when oil prices fall dramatically, the Japanese economy benefits. By using this and many other strong currency/commodity correlations, investors can take advantage of these trends.

Lastly, there are a few inherent advantages simply for using ETFs. They are easy to trade making it possible to buy and sell anytime through any broker. ETFs have a strong degree of transparency where they disclose the exact holding of their funds so you know what you are paying for at all times. Lastly, investors have the same amount of flexibility they would if they were to invest in the actual currency: they can short, open margin accounts, and place limit orders.

Which Currency ETFs to Look At

Now, there are a lot of countries and subsequent currencies out there. So this gives you a lot of different options on where to invest your capital. Below I have provided a few solid picks that have shown strong historical returns at relatively affordable expense ratios.

Emerging Market Exposure

WisdomTree's Dreyfus Emerging Currency Fund (NYSEARCA:CEW) seeks total returns reflective of money market rates and changes in value of its constituent currencies based on the US dollar. With a .55% expense ratio and a 3.55% return over the past year, this is definitely a good place to not only hedge away from US equities, but also to get exposure to the high-growth emerging market economies.

Holdings:

(click to enlarge)

G10 Exposure

Invesco's PowerShares DB G10 Currency Harvest Fund (NYSEARCA:DBV) is an index fund that uses currency futures on G10 currencies to exploit the trend that currencies associated with relatively high interest rates, on average, tend to rise in value relative to currencies associated with relatively low interest rates. This is a pretty interesting fund that has had some great returns over the last 5 years. This fund has seen a 17.32% return in the past 5 years, and is up 5.06% this year alone. If you can get over the .75% expense ratio, this is definitely a good place for some broad G10 exposure.

Holdings:

Short EUR Exposure

If you are looking to spice it up, and get very specific, you can go short the Euro with ProShares Short Euro ETF (NYSEARCA:EUFX). This ETF seeks a return that is -1x the return of a specific benchmark (EUR/USD). Essentially, this fund looks to profit from a decline in the Euro. To interject my opinion, the EUR is a sell, in my view. Both the USD and GBP are relatively stronger currencies, and with the ECB's long-term dovish outlook, the EUR would be a good currency to sell. As well, recent readings on growth for the euro countries have disappointed, and inflation fell to a low of 0.4%. We also can see money and credit indicators both below the ECB's target, which is a strong bearish sign for the currency. However, EUFX is only up 2.80% YTD, and with a .95% expense ratio, this is a gamble depending on what you believe the future holds for the Euro.

Holdings:

EUR/USD FUTURE 09/15/2014 (ECU4)

Long USD Exposure

Lastly, you can get exposure to appreciation on the USD through the WisdomTree Bloomberg U.S. Dollar Bullish Fund (NYSEARCA:USDU). This fund profits by price appreciation in the USD as measured by the Bloomberg Dollar Total Return Index. A relatively new fund, USDU has only returned around 1.01% in the past 3 months with a .50% expense ratio. However, with an improving US economy and stronger than expected data across the board, the USD looks poised to perform well relative to currencies like the EUR and JPY, operating in deflationary environments.

Holdings:

(click to enlarge)

Overall

As ETFs grow in popularity, there will be an ever growing opportunity for investors to get exposure to a broad array of assets, specifically currencies. By simply allocating a portion of your holdings to currency ETFs, you can help to reduce overall portfolio risk, while setting yourself up for new avenues of profit. Even if you don't believe a correction is on the horizon, as 2008 taught us, it is better to be safe than sorry.

Source: Correction In Sight? Hedging Equity Exposure With Currency ETFs