The impact of currency fluctuations is a dynamic that more and more investors have taken an interest in over the last several years. A decade ago, it was difficult to trade the currency markets without a dedicated forex account and sophisticated knowledge of the landscape. This was the realm of institutional investors and macro hedge funds. Fast forward to 2017 and there is a myriad of mainstream options to take advantage of these markets in a normal brokerage account.
At present, there are 32 exchange-traded products dedicated to currency trading pairs or indexes. There are also countless other ETFs and mutual funds with embedded currency strategies coupled with stock or bond holdings. These “local currency” or “currency hedged” indexes allow ETF investors the ability to mitigate certain risks of owning foreign investments or take advantage of a specific currency trend.
The question is, do these products fit in the confines of a traditional diversified portfolio?
Those that are considering a currency-related fund should carefully evaluate its potential benefits and risks before making the leap. The price movement of these funds are often predicated on global-macro forces that are outside the realm of conventional asset classes like stocks and bonds. Currencies are often subject to influence from political shuffling, global conflict, trade data, and other economic headlines. Thus, it must be understood that there are varying risk and volatility dynamics at play in the forex markets.
The vehicles that house these indexes also contain their own opportunities and drawbacks. Their strength lies in the ease of which they can be traded and held within virtually any brokerage account. Yet, on the flip side, investors must weigh the expense, tax implications, and tracking error of each individual selection.
For example, the PowerShares DB U.S. Dollar Index Bullish (UUP) is the largest dedicated currency ETF with $870 million in total assets. UUP tracks an index of the U.S. dollar versus six major foreign currencies. The euro is the most notable underlying contract in UUP, with 57.60% of the total allocation. That massive slice of the pie is followed by the Japanese Yen (13.60%), British Pound (11.90%), and Canadian Dollar (9.10%) rounding out the top holdings.
UUP charges an expense ratio of 0.80%, which is on the high side when compared to passive indexes that track traditional asset classes. However, a premium in cost is to be expected for a unique vehicle of this nature.
Furthermore, investors should note that its legal structure is that of a limited partnership rather than a trust. This leads to the additional complication of a K-1 (instead of a 1099) for shareholders in taxable accounts that must be dealt with on your year-end tax return.
Over the last six months, UUP has been on a distinguished ascent as devaluation of foreign currencies versus the U.S. dollar continue to build. This trend also bodes well for currency-hedged international ETFs with short positions in the host country currency.
It’s also worth noting that this fund has done a commendable job in tracking the spot end-of-day cash settlement price for the U.S. dollar index. This 3-year chart shows the tracking error in UUP has been manageable even with the expected drag in fees.
Perhaps more ominous in terms of risk are leveraged ETFs that track a single currency. The ProShares UltraShort Euro (EUO) and ProShares UltraShort Yen (YCS) are two example of this style. Both funds take a 2x approach to magnifying the inverse daily price action of their stated objective. This embedded use of leverage significantly increases the risk of capital invested and leads to larger tracking error over long periods of time.
The Bottom Line
The use of currency ETFs may be appropriate for experienced investors with large positions in international stocks or who understand the dynamics of these markets. They can also be used simply as a visual index for those who want to stay on top of the trends in foreign exchanges.