Diversifying with currency ETFs

By Jason Chow
Globe Investor Magazine Online,
June 20, 2008

Experts who follow exchange-traded funds (ETFs) say the fund managers are often a good measure of what the herd is thinking. When they all start hyping a specific sector, it's time to think of investing somewhere else.

"Whenever a bunch of new funds of the same nature come out, you have to watch out," says Matt McCall, editor of ETF Bulletin in Ridgewood, N.J. "Everybody tries to chase the top."

The latest sector to enjoy attention? Currency ETFs. As the entire world's economy slows and equities slide, investors are looking at alternative assets. This year, buyers have been piling into commodity markets and snapping up oil, gold, metals and grains. But the latest numbers show they are turning to currency markets.

According to the U.S. National Stock Exchange, ETFs that invest in foreign exchange markets represent only 1 per cent of total ETF assets in the U.S. But in July, investors put 6 per cent of all new investments into currency ETFs. By comparison, international equities take up 27 per cent of the overall pie but attracted only 3 per cent of the cash inflow last month.

These currency-specific ETFs make it easy for average investors to get in on currency moves without having to having to learn how to work the complex futures market or having to buy foreign exchange from a money-changing booth at an airport. The companies running the funds do all the leg work - the rest of us just buy and sell the ETF like a stock.

Money managers have responded to the demand with a spate of new funds. Last month, Rydex, which runs the CurrencyShares series of ETFs, released four new currency ETFs that track the Russian ruble, the South African rand, the Hong Kong dollar and the Singapore dollar. Rydex is just the latest entrant: Several other companies offer ETFs that track the euro, the Swiss franc, the Canadian dollar and the Mexican peso.

Currency ETFs have performed well, exploiting the weakness in the U.S. dollar and, in certain cases, buoyed by the commodity boom. WisdomTree South African Rand ETF (SZR/NYSE), rose 7.6 per cent in July alone while the WisdomTree Brazilian Real ETF (BZF/NYSE), went up 3.3 per cent during the same period.

In the past year, the CurrencyShares EuroTrust ETF (FXE/NYSE) has risen from $134.92 (U.S.) to a high of $159.44 in July before retreating to its current $147.27 level. Even after the retreat, the ETF is up 9 per cent from a year before.

With the U.S. dollar sliding over the past three years, many investors are piling on the currency bandwagon. Don Martin, a portfolio manager at Mayflower Capital in Los Altos, Calif., told an investing blog on Business Week three weeks ago that he was recommending that clients stash as much as 50 per cent of their cash in currency ETFs that tracked the euro, the Japanese yen and the Australian dollar.

However, some think the time for the greenback's rebound is now. Mr. McCall, editor of ETF Bulletin, says the rising popularity of currency ETFs is a sure sign the currency boom has peaked.

Last week, he changed his call, advising clients to shift their currency assets away from the euro and other non-U.S. denominations back to the greenback and is recommending the PowerShares US Dollar Index Bullish ETF (UUP/AMEX). The fund tracks the US Dollar Index, which tracks the value of the U.S. dollar relative to a basket of currencies including the euro, yen, Canadian dollar and Swiss franc, among others. UUP has risen 7 per cent in the past three weeks.

"I actually like the U.S. dollar right now. I think its undervalued and this foreign currency rally is way long in the tooth," he said. "By the time all the new funds have come out, the dollar has hit bottom and a new rally is under way."

Mr. McCall recommends no more than 5 per cent of a portfolio be invested in currency ETFs. They should be regarded as a diversification tool, not as a potential big bet.

"It concerns me when average investors get into currencies," he said. "People really don't know how currency markets work and they shouldn't get too involved. It's a tool to diversify. That's it."