American investors deal with currency risk in their portfolios all the time. Even if you limit your portfolio to U.S. stocks, many of those companies likely have operations overseas, and their financial results can vary dramatically depending on the relationship between the U.S. dollar and foreign currencies. However, currency ETFs give investors a way to manage that risk, offering a direct way to profit when foreign currencies rise in value compared to the dollar.

Currency ETFs

ETF

1 share =

Expense Ratio

5-Year Average Annual Return

Guggenheim CurrencyShares Euro Trust (NYSEMKT:FXE)

96.77 euro

0.40%

(3.05%)

Guggenheim CurrencyShares Japanese Yen Trust (NYSEMKT:FXY)

9,622 yen

0.40%

(7.03%)

Guggenheim CurrencyShares Chinese Renminbi Trust (NYSEMKT:FXCH)

491.6 renminbi

0.40%

(1.64%)

Guggenheim CurrencyShares British Pound Trust (NYSEMKT:FXB)

97.39 pounds

0.40%

(4.39%)

Guggenheim CurrencyShares Canadian Dollar Trust (NYSEMKT:FXC)

C$98.68

0.40%

(5.15%)

Guggenheim CurrencyShares Australian Dollar Trust (NYSEMKT:FXA)

A$100

0.40%

(4.05%)

Guggenheim CurrencyShares Swiss Franc Trust (NYSEMKT:FXF)

94.94 francs

0.40%

(1.29%)

WisdomTree Brazilian Real (NYSEMKT:BZF)

N/A

0.45%

(0.68%)

Data source: Fund providers. N/A = not applicable; WisdomTree uses forward contracts rather than holding currency directly, so fund share values don't necessarily correspond to a fixed amount of currency.

How currency ETFs simplify foreign exchange investing

Currency ETFs have been around for more than a decade now, and they have dramatically changed the way many people participate in the foreign exchange markets. Previously, those who wanted to trade in forex had limited options. They could buy foreign currency directly from certain banks and financial institutions, typically with high fees and without the opportunity to earn interest on their foreign cash. Alternatively, one could open a futures account and trade in forex futures contracts, but in that market, highly sophisticated professional investors lay in wait to pounce on forex novices. Moreover, the huge size of futures contracts made forex a dangerous place for those of modest means.

The initial idea behind currency ETFs was to make every share of a fund equal to a fixed amount of foreign currency. For instance, with the CurrencyShares ETFs listed above, each share started out being worth a round number of foreign currency units, such as 100 euro, 10,000 yen, or C$100. When short-term interest rates were high, the expenses of the fund were paid from the interest that the cash generated, leaving the rest to get distributed as dividends.

However, when interest rates fell -- or even went negative in places like Europe -- the income from ETF assets was insufficient to pay the expenses of the fund. Therefore, each fund paid itself from the principal assets, reducing the original round numbers to where they stand today.

Foreign cash.

Image source: Getty Images.

Alternatives to foreign cash-holding ETFs

Not all currency ETFs merely hold foreign currency. For instance, the WisdomTree Brazilian Real ETF owns currency forward contracts, allowing it to hold U.S. cash as its primary asset but to keep exposure to movements in the Brazilian currency. Because of the way forward contracts incorporate interest rate differentials, the exchange rates under forwards vary. Currently, the fund has July forwards with rates of about 3.18 reais  to the dollar, while August forward contracts have rates closer to 3.26 reais.

Some other currency ETFs use futures contracts to achieve the same end. The U.S. Dollar Index is a basket of foreign currencies, with the the euro, yen, and British pound having the largest weightings. ETFs holding Dollar Index futures track that measure, roughly corresponding to the strength of the dollar against major foreign currencies. However, the Dollar Index doesn't let you drill down on individual foreign currencies the way that some currency ETFs do.

Do currency ETFs make sense for your portfolio?

Looking at recent returns from currency ETFs, you might wonder why anyone would hold them. However, the U.S. dollar has been particularly strong over the past five years, and many investors believe that the strong-dollar trend might be reversing itself. If that's the case, then using currency ETFs could potentially let you benefit from a weakening dollar in the future.

Many market participants see foreign exchange as being speculative and a risky place for ordinary investors. There's some validity to that view, but for those seeking ways to protect themselves if the dollar loses ground, buying shares of currency ETFs can be the simplest way to hedge their bets and take advantage of rising forex values if and when they come.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.