Currency ETFs Are a Nice Hedge

Market Vectors Indonesia (IDX) should remain under pressure after two bombings in Jakarta rocked the country. The Indonesian rupiah fell 1% and the stock market declined 0.6%, a combined 1.6% loss for investors marking their trade in dollars.

It highlights the currency risk inherent in international investing, which can lead to much higher- or lower-than-expected returns. For instance, in the past six months, CurrencyShares Japanese Yen (FXY) is down 4%, compared to a 14% gain for the Nikkei. iShares Japan (EWJ) is up only 5%, however, as the currency drag weighed on returns. Investors who were "right" about Japan may nonetheless have seen their gains suffer because they failed to take currency moves into account.

As with commodities, the best way to trade currencies is to head straight to the forex and futures markets, but currency ETFs offer a way for conservative investors to put cash to work or hedge their investments. During last fall's market decline, PowerShares U.S. Dollar Bullish Fund (UUP) and the FXY were two excellent plays. Both funds delivered returns of more than 10% between the end of July and the end of October, while the S&P 500 index suffered a 24% decline. Instead of going straight to cash, investors can use currency ETFs to deliver extra returns on top of sitting out a market decline.

It's also a great way to hedge for investors nervous about the markets. For the past two years, the dollar and yen weakened when risk appetites increased and strengthened when fear increased. Or investors can increase their risk and pile onto a trade, increasing their exposure. Buying emerging-market ETFs along with PowerShares DB U.S. Dollar Bearish Fund (UDN) would give a portfolio heightened exposure to a weak dollar. However, as the IDX example shows today, investors already have direct currency exposure if they own an international ETF holding local stocks.

I have used both UUP and UDN in model and client portfolios. Currently, UDN is in some portfolios due to the near-term outlook. Risk appetites have been increasing since March, and the U.S. dollar weakened from $1.25 to more than $1.40 vs. the euro, which makes up more than 50% of the Dollar Index tracked by UUP and UDN. Since reaching that level in June, however, the euro/dollar has stayed within a very tight range, and our position could change at any time due to market conditions.

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