Jules Staniewicz has worked in the financial industry for 30 years.
He has been the co-head of alternative investments for a major Wall Street brokerage firm and worked for 15 years with a multi-billion alternative investment manager
Over the past few articles I have talked about alternative ETFs, from the basics to precious then base metals. Metals were chosen first because they have attracted the attention of the ETF world, and captured investors’ imagination (as shown by the number of metals-based ETFs near the top of the assets and volume tables). While this is true for ETFs, in the broader investment world, the champion of all investments, alternative or otherwise, is the currency markets. According to the Bank of England and the New York Fed’s most recent survey results in just London and New York (ignoring the rest of the world) the transaction volume was $1.972 trillion per day in London and a mere $977 million daily in New York, dwarfing the stock and bond markets, which themselves dwarf the metals markets. Despite their prevalence in the world financial markets, they are underrepresented in portfolios of U.S. investors.
This is because most investors do not understand currencies. They fall somewhere between arcane and non-existent to most, but whether recognized or not, they affect everyone’s portfolio. The reasons (excuses) for this lack of understanding are many. Part of the issue is the lack of coverage in the financial media. Stock and bond fund companies pay the bills. You never hear, “The next section of our program is brought to you by the exchange rate between the Swiss Franc and the dollar”. So the coverage is relegated to ten second mentions and slow news days. Additionally, Americans have a historically been rather isolated and self-sufficient, and have only reluctantly discovered globalization and the effect here at home. The point isn’t to bemoan the remarkably low percentage of American who even hold a valid passport (28%, according to a 2008 GAO report), but that a relatively small minority of Americans have had experience with the joys of converting what’s left of foreign-currency denominated travelers checks back to dollars for way less than what you paid for them upon your return home from a trip abroad. Without this first-hand experience, the effects of a change in the value of the dollar remain rather abstract.
Even if the interest had been higher, the currency markets did not make it easy for non-professionals to access the markets. Currency futures provided access to the small number who had these accounts, but even there, the daily swings of these large contracts (ranging from $75,000 to $150,000 as the minimum contract size, depending on the currency) prevented most from dabbling. In late 2005, CurrencyShares waded into this enormous market with an ETF to trade the Euro (FXE). They followed this with another half dozen ETFs in mid-2006, all based on different currencies. These were the Australian Dollar (FXA), British Pound, (FXB), the Canadian Dollar (FXC), The Swedish Krona (FXS), the Swiss Franc (FXF) and the Mexican Peso (FXM). With that, ETF investors could now access these markets in their accounts, and size them appropriately. From there, as is often the case, baskets of currencies were introduced within a single ETF, allowing exposure to a number of currencies at once. PowerShares introduced their PowerShares DB G10 Currency Harvest Fund (DBV), followed soon by their Dollar Index Fund (UUP), and its inverse, the bearish dollar (UDN). At about the same time CurrencyShares plugged the obvious hole in their menu by launching the Japanese Yen ETF (FXY). In the last few years smaller currencies have also been added, but they tend to be far less liquid, and the rest of the discussion will concentrate on the list above.
With this the tools had been built, but what were investors to do with them? What can these do for a US investor’s portfolio, if anything should be done at all? Ultimately, these funds need to serve a purpose in order to draw investor interest in holding them. Let’s examine what you get if you buy a currency ETF. Currency ETFs are exactly the same as other ETFs and at the same time completely different. They are the same in that if you buy any of these ETFs and the price rises, then you make money. They differ because of the driver behind the changes in price. While equity based ETFs rise because of the conditions that make the broad market rise (and there are a lot of reasons this happens and no real agreement as to which ones are the most important), currency ETFs represent a conversion of dollars into another currency. Thus the price is a relative, not absolute.
Most investors feel they understand what drives the price of stocks. What really drives stocks can be a matter of long debate, but most investors have bought into the capital markets dogma that they are buying a piece of an ongoing enterprise that generates increasing earnings into the future. If this continues, then the value of the enterprise (and hence the price of the stock) goes up. No such simple narrative can be spun for currencies. Theories abound as to what drives the exchange rate – relative interest rates, purchasing power parity, comparative growth, economic expectation, inflationary fears compared to the other nation (to name but a few) – but the complexity of the situation makes consensus about the driver all but impossible.
So investing in a currency or basket will give you a profit or loss based on how that currency or basket does against the US dollar. If the Japanese Yen appreciates against the US dollar, that portion of your portfolio you committed to the Japanese Yen by buying FXY will go up, because it represents buying a foreign currency instead of stocks (or holding dollars in a money market). Here are two charts of how the separate currencies and baskets have done since early in 2007.
You can see that the Yen, Australian Dollar and Swiss Franc have all appreciated strongly against the US dollar over this time period. The Euro and the Canadian Dollar have pretty much broken even, and the British pound is down about 20%. So has the dollar gone up over that time? The answer depends upon the currency against which you are measuring it on a relative basis.
The baskets DBV and the bullish and dollar index UUP have lost ground. We are referring to the Dollar index as a basket because it is a trade-weighted index of twenty currencies, rather than the relative value of one currency. With DBV it is interesting to note (and reiterate a comment from the previous column on things of which to be wary in ETF investing) that despite being long the G10 currencies, the strategy employed of trying to harvest higher relative yields has underperformed during this period. Again be sure one knows what one is buying.
Realize that buying the ETF is a conscious choice NOT to hold dollars for that portion of your portfolio. For whatever you leave in equity ETFs, Fixed Income or money markets, you are holding dollar-denominated assets. Another way to look at this is that whatever you held over this period that was denominated in dollars was worth close to 50% less than if it were denominated in Japanese Yen for the same period. This is the unintended consequence that ignoring currencies has on the relative purchasing power of the portfolio over time. Regardless of whether you make or lose money or break even on traditional investments over this timeframe, the same dollar you have at the end of the period buys fewer Yen (which is to be used for all of the things we like to buy that are priced in yen).