Investors hunt for ways to hedge U.S. dollar exposure as greenback falls
BOSTON (MarketWatch) -- The assault on the U.S. dollar has investors looking to hedge exposure to further weakening in the world's reserve currency, and some are turning to exchange-traded funds for support.
Most individual investors should leave currency trading to speculators, but extremely modest allocations to foreign currencies can act as a hedge for dollar-denominated stocks, bonds and other assets.
Currency exchange-traded funds are just one way to play the dollar's weakness. Investors can also tap ETFs tracking foreign stocks, commodities, inflation-protected bonds and gold. See recent column on gold ETFs.
Foreign-exchange trading has ramped up during the global financial crisis amid the volatility in currencies around the world.
In a report last month, Morgan Stanley analyst Dominic Maister highlighted 16 ETFs that provide direct exposure to a foreign currency relative to the U.S. dollar -- not including exchange-traded notes, which are close relatives of ETFs.
Providers of currency ETFs include Rydex Investments, WisdomTree Investments and Invesco PowerShares. Barclays issues a family of currency ETNs, while ProShares offers leveraged and inverse currency ETFs that let investors make magnified bets on market movements.
Currency ETFs are a tiny portion of the overall business, but they "enable investors to make tactical plays in foreign currencies or to hedge foreign-currency exposure," Maister wrote.
"In our view, the costs for many investors associated with currency ETFs may be lower than the costs associated with trading and investing in other currency-related investments," the analyst said. "In addition, ETFs provide liquidity throughout the day as they are traded like stocks on U.S. exchanges and can be easily shorted."
Still, currency ETFs are different from plain-vanilla funds tracking stocks and bonds, and investors need to be aware of their tax treatment and unique risks.
CurrencyShares
Rydex's lineup of currency ETFs includes several funds with total assets in the range of $500 million, such as CurrencyShares Euro Trust (FXE 147.25, +0.06, +0.04%) , CurrencyShares Australian Dollar Trust (FXA 87.15, -0.42, -0.48%) , CurrencyShares Canadian Dollar Trust (FXC 93.52, -0.21, -0.22%) and CurrencyShares Japanese Yen Trust (FXY 108.99, -0.42, -0.38%) .
The ETFs are structured as grantor trusts and have expense ratios of 0.4%, and investors need to pay broker commissions to trade ETFs, since they are bought and sold like individual stocks.
They hold foreign currencies in overseas interest-bearing accounts, and their value is determined by the movement of that currency versus the U.S. dollar. The Rydex currency ETFs also pay a yield that is tied to local interest rates, minus fees. CurrencyShares pay interest income on a monthly basis, which is taxed as ordinary income. Meanwhile, any short-term or long-term gains in the ETFs due to currency moves are taxed at the ordinary rate up to 35%.
Morgan Stanley's Maister pointed out that investors in the CurrencyShares ETFs do not have FDIC insurance and therefore assume the credit risk of the depository bank, J.P. Morgan Chase (JPM 45.05, +0.09, +0.20%) .
