Currency ETFs: Dollar Hedging and the Carry Trade

Currency ETFs really showed their usefulness during the last two years. Not only did they help investors avoid calamitous losses in the stock market, they also sidestepped a dramatic slide by the US dollar against nearly every other currency.

A currency ETF typically exchanges Dollars for foreign currencies while earning a bit of additional interest income in short-term instruments.

For passive single-currency ETFs the first question is: does the it track the target currency reasonably well? The answer is generally yes. In the popular Euro arena, two our of three ETFs track quite well and the third does so adequately:

Both WisdomTree Dreyfus Euro ETF (NYSEArca:EU - News) at .35% annual expenses and CurrencyShares Euro Trust (NYSEArca:FXE - News) at .40% fees hover around the Euro spot price consistently. iPath EUR/USD Exchange Rate ETN (NYSEArca:ERO - News), with .40% fees, does a less impressive job. Investors should realize that seeking out short-term yields (at low risk) can contribute to minor tracking error. Also, tracking error is just as likely to be positive as negative, so it should not be feared unduly.

Other European currency ETFs include:

• CurrencyShares British Pount Sterling Trust (NYSEArca:FXB - News); expense ratio .40%
• CurrencyShares Swedish Krona Trust (NYSEArca:FXS - News); expense ratio .40%
• CurrencyShares Swiss Franc Trust (NYSEArca:FXF - News); expense ratio .40%
• iPath GBP/USD Exchange Rate ETN (NYSEArca:GBB - News), .40%

The Japanese Yen is another major currency well-served by ETFs, including:

• CurrencyShares Japanese Yen Trust (NYSEArca:FXY - News), .40% annual fees
• iPath JPY/USD Exchange Rate ETN (NYSEArca:JYN - News), .40% annual fees
• WisdomTree Dreyfus Japanese Yen ETF (JYF), .35% fees

For a more active-minded investor, an interesting strategy is adopted by iPath Optimized Currency Carry ETN (NYSEArca:ICI - News). ICI systematically engages in the carry trade whereby low-yielding currencies are borrowed and exchanged for high-yielding ones. For instance, in 2008 ICI sold the Dollar to invest in the Euro and the Yen. In 2009 it invested most heavily in the Norwegian Krone based on borrowings from the Swedish Krona.

Because interest earned is less than interest paid on borrowings, there is locked-in interest income, but fees nibble into that and it comes at the risk that invested currencies (long) will fall while currencies borrowed (sold short) will rise. In ETFs tthe decision on what to buy and sell is not done subjectively. A standard optimization formula dictates the moves and takes into account expected risk and return with the goal of obtaining the best theoretical risk/reward ratio.

Active management, of course, does not guarantee superior returns as the following graph shows:

Passive Euro and Yen-based currency ETFs beat ICI handily in the past 12 months. But during its short lifespan, ICI has shown itself to be somewhat less volatile than most other pure currency plays. Much of this is due to its multiple-currency pool. Fees are .65%

PowerShares DB G10 Currency Harvest Fund (AMEX:DBV - News) is a somewhat similar ETF with fees of .0.75%. It buys US T-Bill for collateral to buy futures for three G10 currencies earning high interest and to sell futures for three G10 currencies earning low interest. It took a brief hit over the weekend of October 4-5, 2008, when European governments scrambled to fashion a bailout and futures markets went haywire.

An active fund with a regional focus is Barclays Asian and Gulf Currency Revaluation ETN (NYSEArca:PGD - News), with annual fees of 0.89%.

Important country or regional ETFs include:

• CurrencyShares Australian Dollar Trust (NYSEArca:FXA - News), .04% fees
• CurrencyShares Canadian Dollar Trust (NYSEArca:FXC - News), .04% fees
• CurrencyShares Euro Trust (NYSEArca:FXE - News), .04% fees
• CurrencyShares Mexican Peso Trust (NYSEArca:FXM - News), .04% fees
• CurrencyShares Russian Ruble Trust ETF (NYSEArca:XRU - News), .04% fees

Betting for or against the dollar is perhaps the simplest way for dollar-denominated portfolios to hedge or speculate on currency risk. ETFs for this purpose include:

• PowerShares DB US Dollar Index Bullish Fund (AMEX:UUP - News), .50%
• PowerShares DB US Dollar Index Bearish Fund (AMEX:UDN - News), .50%

Both are straightforwarding trading tools which buy and sell futures contracts on the dollar and other major currencies. UUP aims to prosper if the dollar strengthens relative to a basket of other major currencies. It has been a loser in recent years but if the Dollar falls much further it could be quite compelling. During most periods when currency exchange rates are stable an investor is better off simply to leave Dollars in a short-term Treasury ETF. Fees of .50% are reasonable for a trading vehicle.

UDN is the mirror trading tool of UUP. It buys into a basket of futures of the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc, hoping they will rise relative to the Dollar. With the Dollar down considerably, it has captured much of its potential upside but with monetary inflation rampant could have further to go.

Investors will be disappointed to know that most currency ETFs generate high ordinary income taxes. The IRS considers most of them debt, so interest proceeds are ordinary income. Worse still, gain on the sale of a fund is taxed at ordinary income rates, not the much lower capital gains rate. An exception can occur with multiple-currency ETFs, however investors should consult with a tax accountant to confirm this for any specific fund.