Currency Investing: Making Money on Money

|
 |  Includes: DBV, FXA, FXB, FXC, FXE, FXF, FXM, FXS, FXY, UDN, UUP
by: Ray Hendon

In years past, I have invested indirectly in foreign currencies by owning foreign bond and equity mutual funds that were un-hedged. That was the only way of getting foreign currency exposure in amounts I could afford. But now, the world is changing. Thanks to ETFs an average investor can readily and inexpensively own foreign currencies. The question, though, is: Do these instruments have a proper role in your portfolio? Or, now that you can buy foreign currencies, should you?

As you might expect, opinion on this issue is divided, and there is no unambiguous or definitive answer. It depends on how you view the risks and rewards. If you crave risks, then currency trading (as opposed to investing) may be a good way to go. Foreign currencies constitute the largest and most liquid market in the world, averaging over $8 trillion a day in trades—24 hours a day. If you love staring at a computer screen at 2:00 a.m., waiting for the exact moment to pounce on a move of 1/1000th of a point, currency trading may be for you. If you like using extreme leverage, say 200-1, start looking for a Forex broker. They are eager for your business.

For these who choose this approach, I can only say, “good luck”. My ability to predict a pip (1/1000th of a dollar) is completely lacking--I am, as they say, overmatched in this arena. In my view, investors should leave that kind of activity to the professionals--those who take theirs off the top. Otherwise, you risk becoming someone else's fodder.

But, currency as an asset in your portfolio may have a role if you own it as an investor rather than as a speculator. You can buy and hold currencies, and you can trade without leverage. But, should you? Those who are against holding foreign currencies use the argument that doing so is a zero sum investment--currencies have no expected returns, or more accurately, their long-term expected returns are zero. It is known that economic tides may flow in favor of a particular currency over a period of time, but it is also known that when the tide recedes, you will lose those gains. The problem, then, is that you can’t predict when the tide will turn. Therefore, they say, don't buy currency as an investment; they have no prospects for long term growth.

The other side will admit the fundamentals of this argument. Certainly currencies of themselves have no way to multiply. But, currency movements are often counter-cyclical to equity prices, so holding a diversified basket of currencies may help stabilize your portfolio and help keep you in the game when your equities are tanking. Also, the proponents add, currency can be deposited in interest bearing accounts or used to collateralize bond ownership, so owning currencies will generate interest earnings for your portfolio as providing stability. To me these argument make sense. If you can take the political uncertainty that goes with currency ownership, then holding currency may enhance your financial position.

For those who can see the plus side of the investing argument, it is possible to buy currencies through low-cost ETFs. The simplest way is to establish a long position in a single country's currency or a basket of currencies if you want to spread your risks. For now, only Rydex has ETFs in this category. Table 1 gives you a look at their offerings.

These ETFs can be bought long or short, and they pay interest tied to the prevailing interest rate in the host country. In this sense, they are not completely sterile as an investment over the long haul. But, they do not have the stability of a money market nor a CD, so volatility and risks of devaluation must be kept in mind when choosing an appropriate currency or basket in which to invest. Also, the interest rates paid are not guaranteed, and they can vary from month to month.

The positive returns of each ETF in Table 1 reflects the almost universal decline in the value of the U.S. dollar for the last year (and longer). The outsize returns of the Australian and Canadian dollar reflect the increased strength of these economies vs. the U.S. Both are benefiting from the recent surge in food, mineral, and commodities prices that play to their strengths as providers of these resources.

If the Mexican peso were allowed to float, it would almost certainly have gained more over the last few years because of the rising demand of its primary exports: oil in the legal market—marijuana and heroin in the cash market. But the peso trades under tight controls by the Mexican central bank. It looks as if they limit its price movements to a trading band of around +-1%. The Mexican government sees it as an advantage to keep the peso closely tied to the dollar. The down-side to this strategy is that they risk having to make huge, one-time adjustments through devaluations or revaluations.

A look at Graph 1 shows how this works. I display the Mexican peso and the Australian dollar together in order to get an idea of how each country controls or does not control variations in its exchange rates. Note that Australia's 22.04% annual return shown in Table 1 was achieved by just over a 15% gain in price vs. the U.S. dollar and interest payments (Table 1) of about 7%. The peso’s gain was about 1% in price appreciation with the rest from interest payments.

click to enlarge

In summary, Rydex’s offerings have done well. Only two of their ETFs have yet to attract $100 million. Their success has, I am sure, been something of a beacon for other ETF providers, who, as you will see shortly, are lining up with their own baskets that will come to market soon.

Other Currency Plays

At this moment there are no other single-country plays in ETFs. But, PowerShares offer three bundles of currency futures in some interesting configurations. Understand, of course, that shifting from direct ownership to futures plays more to speculation than investing. Their ETFs are shown in Table 2, below.

The full names of each ETF are:

  • DB G10 Currency Harvest Fund (NYSEARCA:DBV)
  • DB U.S. Dollar Bearish Fund (NYSEARCA:UDN)
  • DB U.S. Dollar Bullish Fund (NYSEARCA:UUP)

These funds use Deutsch Bank indices of U.S. dollar futures against a bundle of currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. They use 3-Month U.S. Treasury bonds as collateral for their futures contracts, so they pay dividends on the interest received from these instruments. The Bearish fund (UDN) follows a short-the-dollar-index vs. a bundle of currencies, and the bullish fund (UUP) uses a long bundle of the same basket. The strategy of the G10 (Group of 10) ETF is to short currencies in low interest rate member countries, and go long in members with high interest rates. This is an ancient approach to currency speculation, but “modernized” by their use of mathematical models, they say.

UDN and UUP have expense ratios of .5% plus futures contracts. Expense ratio for DBV is high, at .75% plus fees for futures contracts. Options are available only for DBV. Investing in futures is simply more expensive and more speculative than buying currency units outright.

In spite of their relatively high costs, PowerShares has been successful with these ETFs. The trading volume is enough to be viable, and it looks as all of them will be in the $100 million range of assets soon.

Waiting in the Wings

With the success of PowerShares and Rydex we should expect other providers to enter the market soon, and so they are. Barclays has three awaiting SEC approval: An Asian and Gulf Currency Revaluation ETN, a GEMS Strategy ETN (Global Emerging Markets), and an Intelligent Carry ETN.

The Carry ETN is quite similar to PowerShares DBV in that it shorts low-interest rate currencies and goes long in high-interest rate currencies—using a different model than PowerShares, of course.

The Asian and Gulf ETN tracks currencies tied to the U.S. dollar. These countries include China and the Gulf Region of the Middle East. The ETF is structured to take advantage of these countries when they revalue their currencies because of the huge decline of the U.S. dollar.

The GEMS Strategy ETN follows fifteen emerging markets currencies, and pays interest as dividends as well as appreciations of their currency against the U.S. dollar, if any.

ProShares is going all out with a huge set of Ultra ETFs, Short ETFs and, finally, Ultra-short ETFs. Ultra means that they look to produce returns that are 200% of non-leveraged currency returns. To accomplish this feat they use leveraged margin accounts to finance their bets. These ETFs will be available for the Euro, Australian Dollar, Canadian Dollar, British Pound, Japanese Yen, Mexican Peso and the Swedish Krona. I have to tip my hat to ProShares: they know how to appeal to those with an appetite for risk in the investment community.

Finally, Wisdom Tree has 11 currency ETFs awaiting approval. These are conventional single-country holdings (plus the Euro), all long, but they can be shorted. The currencies are: Australian Dollar, Brazilian Real, British Pound Sterling, Canadian Dollar, Chinese Yuan, Euro, Indian Rupee, Japanese Yen, New Zealand Dollar, South African Rand, and the South Korean Won. These are welcome additions to the limited list that is available now.

All in all, it looks to be exciting for those who want to add this asset class to their holdings. You can just about choose any level of risk you want to take with a wide range of currencies. Until now, the selection for holding has been severely limited, unless you buy through currency brokers who sell on the spread and usually in pairs. The current and new offerings will, it seems to me, open currency trading and investing to levels never seen before. And with current trading reaching $8 trillion a day, it's hard to imagine what it will be in the not too distant future.