Is Now the Time for Currency ETFs?

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After a big rally from last year's lows, the dollar has started to sink again. Many people see the massive government stimulus as a sign of future dollar weakness, and savvy investors want to profit from the dollar's troubles. If you want to protect yourself against a dollar decline, exchange-traded funds based on the values of various foreign currencies make it easy.

In the past, taking positions in foreign currency markets took a lot more work. You could use futures contracts, but that often required opening a separate brokerage account. In addition, futures involve large amounts of currency -- a single futures contract controls 125,000 euro, or 12.5 million yen. Those amounts are larger bites than many investors wanted to take.

Other options were equally unattractive. Companies such as American Express (NYSE: AXP  ) and Wells Fargo (NYSE: WFC  ) will let you buy relatively small amounts of foreign currency. But transaction costs are often relatively high, and the currency you buy doesn't pay you any interest.

A simpler way
When currency ETFs became available in late 2005, they offered a much easier way for average investors to play the currency market. The concept of the CurrencyShares Trusts is simple: Take investors' dollars and buy foreign currency with them. So each share of the CurrencyShares euro Trust (NYSE: FXE  ) represents 100 euro, while the CurrencyShares Japanese Yen Trust (NYSE: FXY  ) holds 10,000 yen per share. By choosing how many shares to buy, investors can easily get as little or as much foreign-exchange exposure as they want.

Moreover, investors receive dividends on their ETF shares, with interest rates based on those prevailing in that particular currency. For instance, the Yen Trust pays no dividend because Japanese interest rates are extremely low, but the euro Trust pays a dividend that yields nearly 3%.

As the dollar's value has climbed, however, investors have lost much of their interest in currency ETFs. The euro Trust, for example, is barely a quarter the size it was less than a year ago. That's understandable in light of their steep declines -- the euro Trust is down 12% in the past year, while similar funds for the Canadian dollar and British pound have lost even more ground. And bad performance from European stocks like Nokia (NYSE: NOK  ) has dampened investor demand for the currency, raising the question of whether the euro too is vulnerable to the impact of the financial crisis.

Risk-free cash, or rampant speculation?
For investors, currency ETFs have two distinct and contradictory facets. On one hand, they closely resemble savings accounts; the ETFs hold cash and invest it with banks to get interest. So when measured in the appropriate foreign currency, your shares are unlikely to gain or lose much value -- a share worth 100 euro now will probably be worth close to 100 euro next month or years from now. That distinguishes these ETFs from foreign bonds, whose value moves up and down even in local currency terms.

However, if you're a U.S. investor, changes in exchange rates make currency ETFs much more speculative. While that has hurt investors during the dollar's recent bounce, it could be highly beneficial if the dollar resumes its downtrend. These funds can be extremely volatile, so they're not for the faint of heart.

What to do
In general, diversification is useful. Even though foreign stocks like Petrobras (NYSE: PBR  ) and Baidu (Nasdaq: BIDU  ) lost just as much ground as U.S. stocks during the bear market, they've also rebounded well -- and may continue to bounce back more quickly than domestic company stocks. Similarly, diversifying some of your short-term savings by putting it in foreign currency ETFs can protect you if the dollar falls.

But the one thing you have to remember is that you can lose money in these funds. In fact, even small movements in the foreign currency markets can cost you a lot of your investment principal.

So if you're looking for a sure thing, currency ETFs definitely aren't the answer. But if you understand the risks, buying currency ETFs with a small fraction of your cash holdings may play a useful role in diversifying your portfolio.

For more on international investing, read about:

If you think the best investments lie beyond the borders of the U.S., you should check out the Fool's Global Gains newsletter service. Each month, our experts scour the globe to find the best international stocks for your portfolio. Enjoy a free 30-day trial; there is no obligation to subscribe.

Fool contributor Dan Caplinger has a few hundred Canadian dollars in his sock drawer -- just in case. He doesn't own shares of the companies and funds mentioned. Baidu is a Motley Fool Rule Breakers selection. American Express and Nokia are Motley Fool Inside Value selections. Petrobras is a Motley Fool Income Investor recommendation. The Fool owns shares of American Express. The Fool's disclosure policy works around the world.

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