U.S. investors face a huge potential problem in their portfolios: currency risk. Yet many of them never even realize it. With currency ETFs, though, investors now have the power to hedge their exposure to the U.S. dollar in a way that could produce big profits if the dollar declines in the future. Let's take a closer look at what currency ETFs are and how they can help you manage currency risk in your portfolio.
Making currencies easy
Before currency ETFs came along, trading the foreign exchange markets was relatively difficult. Investors had a few different options to bet on movements in the dollar versus foreign currencies. You could buy foreign currency directly from banks or at currency-exchange kiosks at airports and other locations, but the transaction costs remain unacceptably high for any serious investor, and holding foreign cash doesn't give you any interest. Yet on the other end of the spectrum, forex futures contracts give you professional-level exposure to currency fluctuations, but you have to be willing to take massive positions, as single standard-size futures contracts often represent six-figure sums in U.S. dollar terms, and even specialized small contracts get into five figures.
Currency ETFs have been around for more than seven years now, and they've bridged the gap between high-value futures contracts and the local bank's currency exchange desk. The way most currency ETFs work is simple: Each share of the ETF represents a certain fixed amount of foreign currency, and so the cost of the share in dollar terms goes up and down along with changes in the exchange rate between the dollar and that foreign currency.
For instance, one of the largest players in the currency ETF market is CurrencyShares, which has a wide variety of ETFs targeting different markets. Each share of CurrencyShares Canadian Dollar (NYSEMKT:FXC), for instance, represents 100 Canadian dollars, while shares of CurrencyShares Japanese Yen (NYSEMKT:FXY) are each worth 10,000 Japanese yen.
In addition to moving along with currency fluctuations, currency ETFs usually invest in instruments that pay at least small amounts of interest. In some cases, as with the CurrencyShares Euro (NYSEMKT:FXE), low interest rates are insufficient to pay all of the fund's expenses. But in markets with higher interest rates, as with the CurrencyShares Australian Dollar (NYSEMKT:FXA), you'll receive modest dividends from your ETF holdings -- about a 3% yield in the case of the Australian currency ETF.
Insurance or gambling?
With the flexible trading that exchange-traded funds offer, currency ETFs are easy to buy and sell whenever the markets are open. That makes them easy to use for speculation as well as for legitimate attempts to hedge U.S. dollar exposure.
But with recent trends in the global economy, the line between speculation and hedging has become very blurry. Rhetoric from world leaders, especially among emerging markets, about the need to replace the U.S. dollar as the world's reserve currency has become a lot quieter lately, especially as the dollar has risen dramatically in value against the Japanese yen over the past year. Still, as budget debt balances in the U.S. continue to rise, it's easy to envision a situation in which reducing the value of the dollar benefits the government in handling its debt -- while hurting those investors who rely on the dollar maintaining its value.
New ways to play
With the introduction of the PIMCO Foreign Currency Strategy ETF, an actively managed fund that will use various analytical tools to decide which currencies to target for maximum exposure to better returns as well as protection against a future dollar decline, interest in currency ETFs is likely to soar in the weeks and months to come. But the long-term viability of currency ETFs depends on their ability to provide better returns than U.S. dollar-denominated assets. Given the steady decline in the dollar's value for decades, that seems like a reasonable bet for the future as well.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.