By Brian O’Connell
Former President Ronald Reagan once defined inflation as “violent as a mugger, as frightening as a mugger, and as deadly as a hit man.”
Our 40th president wasn’t exaggerating. Inflation is nature’s financial way of eating your income without you knowing it – or at least not right away.
That’s the case right now. According to the U.S. Labor Dept., the annual rate of inflation rose from 2.1% to 2.7% in March, 2011 http://www.usinflationcalculator.com/date/2011/04/. Consumer prices have also hit a two-year high, the Labor Dept. says.
Creeping inflation has anxious investors looking for an edge. Increasingly, savvier investors are turning to a surprising – yet effective – inflation-fighting tool – currency exchange traded funds (ETFs).
That’s especially true of non-U.S. currency ETFS. With the dollar losing value against other global currencies, a hedge in a fund that tracks foreign currencies can keep you one step ahead of inflation, and one step closer to your investment goals.
Sound good? At first glance, sure. But don’t go into the currency ETF market with blinders on. Currencies are a unique beast, and they’re treated and traded differently than standard equities. Let’s take a look at currency ETF’s and see if they have an inflation-fighting role in your portfolio:
What is the currency market? – Currency trading traces its origins in the global Forex market – the largest capital market in the world at $3.2 trillion in daily transactions. Highly speculative in nature, Forex trading is comprised of global partners; mostly banks, central banks, institutional investors, retail brokers and investors, and large corporations. In a word, these investors buy and sell currencies on an over-the-counter basis (there is no central exchange for trading currencies). The Forex market, more formally known as the foreign exchange market, enables investors to evaluate currencies based on a country’s economic and political situation, which normally are the most significant drivers of currency rates.
What are currency ETF’s? – Currency ETF’s allow investors to speculate in the currency market without the risk of investing directly in currencies, and without entering the Forex market. Like all ETFs, currency funds enable investors to invest in a single currency or basket of currencies, while still taking full advantage of fluctuations in the currency market. Most major global currencies – think the U.S. dollar, the Canadian dollar, the Chinese Yuan, the British pound, or the Brazilian real – can be invested in via currency ETF’s. Altogether, global currency ETFs now hold about $6 billion in assets http://www.ibtimes.com/articles/134976/20110415/the-u-s-dollar-jump-aboard-or-move-aside-uup-udn.htm.
Benefits of currency ETF’s – Most U.S investors have their entire portfolios stocked with U.S. companies, and thus are tied directly to the fortunes of the U.S. dollar. Currency ETF’s, particularly given the precarious state of the U.S. economy these days, allow U.S. investors some much-needed exposure to non-U.S. currency exposure.
Drawbacks of currency ETF’s – Currencies are notoriously fast-moving investments. If you’re not prepared to do your homework, or if you’re blind-sided by geopolitical events (like the crash of the Japanese economy following the earthquake and tsunami that hit the country in March, 2011), then think twice before committing any cash to the currency market.
How are currency ETF’s traded? – You can buy a currency ETF that focuses on a single country currency, or you can mix and match currencies within a single ETF, hoping that the better performing currencies override the poorer-performing ones.
What are some of the most popular currency ETF’s? – There are seemingly as many currency ETF’s as Baskin-Robbins has flavors of ice cream. Find a complete list of currency ETFs at Stock-Ecyclopedia.com http://etf.stock-encyclopedia.com/category/currency-etfs.html. To keep it simple, consider a conventional play: the PowerShares DB US Dollar Index Bullish (Stock Quote: NYSE: UUP), which tracks the performance of the U.S. dollar against key global currencies, like the yen and the pound. If the dollar rises, the fund goes up; when the dollar declines, the fund’s value declines. To make a contrarian play, the PowerShares DB US Dollar Index Bearish (Stock Quote: NYSE: UDN) works the opposite way; when the dollar declines, the fund fares better.
Trading strategies – Another school of thought on currency ETF is to treat them as short-term investment vehicles. If you can identify a key economic barometer, like lower energy prices in a given region over the course of the next month or two, then you can hone in on a currency fund comprised of that country’s currency, make a quick killing, and then get out and pop the proceeds into a more conventional investment, like a commodity-based ETF. If you’re bent on becoming a regular currency ETF investor, just take that advice and rinse and repeat – just makes sure you do your due diligence first. Make sure to focus your research on interest rates in a given country – they’re usually the number one factor that impacts currencies – good and bad – in the currency marketplace.
The takeaway? The currency ETF market is the poster child for the phrase “there’s always a bull market somewhere”. If you dig in, do your homework, study global interest rate patterns, and invest opportunistically, then currency ETFs could be for you.
If not, there’s always a large-cap fund out there with your name on it.
You can easily track the performance of the top 30 currency ETFs, as selected and measured by the web site ETFdb, at http://etfdb.com/etfdb-category/currency/