The currency market (called the foreign exchange, forex, or the
FX market) is the largest and most liquid market in the world. The
volume of FX trading is over 3 trillion dollars per day, which is
an order of magnitude greater than the trading volume on all the
world's stock exchanges combined. In the past, it was difficult for
retail investors to gain access to this market since you had to
open an account with a forex broker. All this changed in 2005 when
Rydex Investments launched the first currency Exchange Traded Fund
)) based on the value of the Euro. Now there are over 29 currency
ETFs and one currency Closed End Fund ((
Let me be clear, I am not an expert on the FX market and do not
have an account with a forex broker. However, as an investor, I am
interested in any asset class that might enhance my retirement
portfolio. One of the characteristics of currency funds is that
they are not correlated with the stock market so they offer the
potential for diversification. To determine if these funds are
suitable for my portfolio, I analyzed the risk versus reward of
these assets over the past 5 years.
Retail investors may not be familiar with the characteristics of
currency funds so I will provide a quick tutorial before presenting
the results of my analysis. The primary reason for the FX market is
to facilitate the exchange of one currency into another by
multi-national corporations. On a much smaller scale, everyone who
has traveled abroad is familiar with foreign exchange rates. If you
travel to Europe, you will need to convert your dollars to euros at
the current rate of 0.72 euros per dollars. So if you buy a product
for 72 euros it will cost you $100 in terms of dollars. This rate
is not fixed. For example, in 2010 the dollars was worth .80 Euros
so the same 72 Euro product would have cost only $90 dollars. This
was because the dollar was "stronger" in 2010 than it is today.
The above illustrates that currencies are traded as pairs based
on the price of one currency in terms of another. The seven most
liquid pairs are (where dollar without a qualifier refers to the
- Dollar/Japanese Yen
- British Pound/Dollar
- Dollar/Swiss Franc
- Australian Dollar/Dollar
- Dollar/Canadian Dollar
- New Zealand Dollar/Dollar
Some other aspects of the currency market are:
- Trading currencies is a zero-sum game, as opposed to trading
stocks which have a long-term positive expectation. If one
currency appreciates, another currency must depreciate.
- The forex market is open 24 hours a day from the start of the
business day on Monday in the Asia-Pacific time zone to the
Friday close of business in New York.
- Currencies are not traded on an exchange and trading is not
controlled by a clearing house or a central governing body.
- There are no commissions. Brokers make money on the spread
between the buying and selling price.
- There are no limits on the amount of currency you can buy. If
you wanted to buy $1 billion U.S. dollars, the transaction could
be easily accommodated.
- The value of a currency is established by supply and demand.
Some factors influencing the demand include interest rates,
inflation and stability of the economy. The supply can be
affected if governments intervene in the market to buy or sell
huge quantities of currency. For example, if Japan wants to
increase the popularity of their exports, the government may want
to weaken the yen, which will make Japanese goods more attractive
to foreign buyers. This could lead to "currency wars" where
governments jockey for position in the international trade
markets. These political interventions may result in unnatural
fluctuations in the market.
- The currency "carry trade" is a strategy where the investor
sells a currency with a low interest rate and buys a currency
with a higher interest rate. The investor tries to profit from
the difference between the two rates.
To limit the number of funds I included in my analysis, I did
not include any inverse or bear funds and required the funds to
meet the following criteria:
- Have at least a 5 year history
- Trade at least an average of 50,000 shares per day
- Have a market cap of at least $150 million.
The ETFs and CEFs described below passed my screen.
PowerShares DB US Dollar Index Bullish (
This ETF tracks the U.S. dollar against a basket of currencies
consisting of the euro, Japanese yen, British pound, Canadian
dollar, Swedishkrona and the Swiss franc. The euro is weighted at
58%, the Japanese yen at 14% and the British pound at 12%. The
other currencies make up the remaining 16%. The fund uses future
contracts to maintain the currency exposure. UUP is structured as a
limited partnership, so investors will receive a K-1 form at the
end of the year rather than a 1099 form. The fund does not pay any
dividends and the expense ratio of 0.75%.
PowerShares DB G10 Currency Harvest (
This EFT implements a "carry trade" strategy, using a quantitative
strategy for buying and selling future contracts. This makes a
sophisticated "hedge-fund" strategy available to individual
investors with a tiny fraction of the fees charged by hedge funds.
The fund can select from any currency used by the following
countries: United States, Canada, Japan, Australia, New Zealand,
Great Britain, Switzerland, Euro Zone, Norway or Sweden. The fund
utilizes 2 times leverage and buys higher yielding currencies while
shorting the lower yielding currencies. Because this fund uses
future contracts and is structured as a limited partnership, it has
some unique tax consequences that should be discussed with your tax
advisor. The fund does not pay any dividends and has an expense
ratio of 0.81%.
CurrencyShares Australian Dollar Trust (
The Currency Shares funds are managed by Guggenheim Investments who
purchased Rydex in 2010. FXA is an ETF designed to track the price
of the Australian dollar. It is organized as an exchange traded
grantor trust, which means that the fund invests in a static basket
of Australian dollars. Each share of the fund represents a
fractional interest in this portfolio of Australian dollars. The
fund yields 2% and has an expense ratio of 0.40%.
CurrencyShares Canadian Dollar Trust (FXC).
This ETF is designed to track the price of the Canadian dollar.
Similar to FXA, this fund is also organized as a grantor trust that
invests in Canadian dollars. The fund yields 0.2% and has an
expense ratio of 0.40%.
CurrencyShares Euro Trust (FXE).
This ETF is designed to track the price of the Euro. It is a
grantor trust that invests in the Euro. It does not generate any
yield and has an expense ratio of 0.40%.
CurrencyShares Japanese Yen Trust (FXY).
This ETF is designed to track the price of the Japanese Yen. It is
a grantor trust that invests in the Yen. It does not generate any
yield and has an expense ratio of 0.40%.
WisdomTree Chinese Yuan Strategy (CYB).
This ETF seeks to achieve a total return associated with the
interest rate in China and changes in value of the Chinese Yuan.
Since the money market Chinese securities are not very liquid, the
fund employs a sophisticated strategy based on forward contracts
and currency swaps to achieve its objectives. The fund is
short-term oriented, generally having a portfolio maturity of 90
days or less for money market instruments and a maturity of 6
months or less for forward contracts. The fund yields 0.8% and has
an expense ratio of 0.45%.
Nuveen Diversified Currency Opportunity (JGT).
The CEF sells at a discount of 16.2% which is slightly below its
average discount of 14.5%. The fund's objective is to seek current
income and total return by investing in short duration global
bonds, forward currency contracts and other derivatives. The
portfolio consists of about 60% foreign Government bonds
denominated in local currency, 11% invested in foreign Government
bonds denominated in U.S. dollars, 9% in investment grade corporate
bonds, 7% in U.S. treasuries and 6% in high yield bonds. In terms
of geographic distribution, 20% of the assets are from the U.S.,
15% from Brazil, 13% from Canada, 12% from Mexico and the rest from
other countries. The fund does not use leverage and has an expense
ratio of 1%. The distribution is a high 8.4% but over 50% comes
from return of capital.
To compare the performance of currency funds with U.S. Treasury
Bonds, I used the
iShares 7-10 Year Treasury Bond (IEF)
ETF as a reference. This ETF tracks the Barclay U.S. 7-10 Year
Treasury Bond index, yields 1.75% and has an expense ratio of
To begin the analysis, I utilized the Smartfolio 3 program to
plot the rate of return in excess of the risk free rate (called
Excess Mu on the charts) versus the volatility of each stock. The
results are shown in Figure 1 for a 5 year look-back period.
(click to enlarge)
Figure 1: Reward and Risk over 5 years
The figure indicates that there has been a wide range of returns
and volatilities associated with currency funds. For example, FXA
had the highest return but also had a high volatility. Was the
increased return worth the increased risk? To answer this question,
I calculated the Sharpe Ratio for each fund.
The Sharpe Ratio is a metric, developed by Nobel laureate
William Sharpe that measures risk-adjusted performance. It is
calculated as the ratio of the excess return over the volatility.
This reward-to-risk ratio (assuming that risk is measured by
volatility) is a good way to compare peers to assess if higher
returns are due to superior investment performance or from taking
additional risk. On the figure, I also plotted a red line that
represents the Sharpe Ratio of IEF. If an asset is above the line,
it has a higher Sharpe Ratio than IEF, which means it has a higher
risk-adjusted return. Conversely, if an asset is below the line,
the reward-to-risk is worse than IEF.
Some interesting observations are apparent from the plot. With
the exception of CYB, all the currency ETFs were more volatile than
intermediate U.S. Treasury bonds. The Chinese yuan had
exceptionally low volatility, likely because it has been
manipulated by the Chinese government. However, the yuan may be
more volatile in the future since the People's Bank of China has
announced that it will widen the trading bands around the yuan.
In general, intermediate Treasury bonds, as exemplified by IEF,
had a significantly better risk-adjusted performance than the vast
majority of currency funds. Only the Australian dollar had a higher
Sharpe Ratio than IEF. The risk-adjusted performance of the closed
end fund JGT equaled that of IEF and DBV was not far behind. The
other ETFs booked significantly poorer performance with FXE, FXY,
and UUP actually featuring negative returns over the period.
On the plus side, the currency ETFs and CEF did live up to their
reputation of providing diversification. To be "diversified," you
would choose assets such that when some assets are down, others are
up. In mathematical terms, you want to select assets that are
uncorrelated (or at least not highly correlated) with each other.
To assess diversification, I calculated the pair-wise correlations
associated with the currency funds and IEF. For comparison with the
overall stock market, I also included the
SPDR S&P 500 (SPY)
ETF. The results are shown in Figure 2.
(click to enlarge)
Figure 2. Correlation matrix over past 5 years
The Chinese yuan is only slightly correlated with the other
assets, which was expected because of the non-free-market nature of
yuan fluctuations. With the exception of the yen and dollar, the
currency funds were negatively correlated with U.S. treasuries. The
dollar was only slightly correlated with IEF and the yen was
moderately correlated. In addition, the yen and dollar were
negatively correlated with the S&P 500 while the other currency
funds were moderately correlated. Since currencies are a zero sum
game, it is not surprising that, with the exception of the yen, the
other currencies were negatively correlated with the dollar.
Overall, the currencies provided moderate-to-excellent
diversification with respect to one another.
As we have seen, over the 5 year look-back period, only a few of
the currency funds (FXA, DBV, and JGT) performed well when compared
to IEF. Did this performance continue for the more recent past? To
answer this question, I re-ran the analysis for the past 3 years.
The results are shown in Figure 3.
(click to enlarge)
Figure 3. Risk versus Reward over past 3 years
Unfortunately, all the currency funds had poor performance over
this time period. With the exception of CYB, all the funds
significantly lagged IEF on both an absolute and risk-adjusted
basis. In fact, only CYB and DBV were able to book a positive
No one knows what the future will hold, but for me, the
diversification I might receive from investing in currency funds
does not compensate for the potential dismal performance. Based on
this data, I would be wary of adding currency funds to my
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
AudioCodes: Shame On Me! Shame On You?