U.S. investors face a huge potential problem in their portfolios: currency risk. Yet many of them never even realize it. With currency ETFs, though, investors now have the power to hedge their exposure to the U.S. dollar in a way that could produce big profits if the dollar declines in the future. Let’s take a closer look at what currency ETFs are and how they can help you manage currency risk in your portfolio.
Making currencies easy
Before currency ETFs came along, trading the foreign exchange markets was relatively difficult. Investors had a few different options to bet on movements in the dollar versus foreign currencies. You could buy foreign currency directly from banks or at currency-exchange kiosks at airports and other locations, but the transaction costs remain unacceptably high for any serious investor, and holding foreign cash doesn’t give you any interest. Yet on the other end of the spectrum, forex futures contracts give you professional-level exposure to currency fluctuations, but you have to be willing to take massive positions, as single standard-size futures contracts often represent six-figure sums in U.S. dollar terms, and even specialized small contracts get into five figures.
Currency ETFs have been around for more than seven years now, and they’ve bridged the gap between high-value futures contracts and the local bank’s currency exchange desk. The way most currency ETFs work is simple: Each share of the ETF represents a certain fixed amount of foreign currency, and so the cost of the share in dollar terms goes up and down along with changes in the exchange rate between the dollar and that foreign currency.
For instance, one of the largest players in the currency ETF market is CurrencyShares, which has a wide variety of ETFs targeting different markets. Each share of CurrencyShares Canadian Dollar Trust (NYSEARCA:FXC) , for instance, represents 100 Canadian dollars, while shares of CurrencyShares Japanese Yen Trust (NYSEARCA:FXY) are each worth 10,000 Japanese yen.
In addition to moving along with currency fluctuations, currency ETFs usually invest in instruments that pay at least small amounts of interest. In some cases, as with the CurrencyShares Euro Trust (NYSEARCA:FXE) , low interest rates are insufficient to pay all of the fund’s expenses. But in markets with higher interest rates, as with the CurrencyShares Australian Dollar Trust (NYSEARCA:FXA), you’ll receive modest dividends from your ETF holdings — about a 3% yield in the case of the Australian currency ETF.