Should You Bet on Currencies?

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About $3 trillion changes hands every day in the world currency markets. No, that’s not a mistake — it is trillion, with a "T."

So it must be profitable for someone. How can the small investor get in on it?

It used to be you had to open a special account for trading currencies. It can be a scary business, with wild, unpredictable ups and downs. If you’re an amateur, you have to be a very, very serious one, as currency bets are usually done for very short periods and must be watched constantly.

Now, it’s a bit easier, with the marketing of a handful of exchange-traded funds and notes that specialize in currencies like the Brazilian real, Australian dollar, euro, peso, yen and so forth. Many investors feel that betting on currencies is the next logical step in diversifying a portfolio.

Morningstar Inc. (Stock Quote: MORN) says about $6.2 billion was invested in the 28 currency funds at the end of March. Investors plowed about $3.7 billion into this relatively new class of funds in 2009.

But maybe adding currencies to a portfolio is more trouble than it’s worth.

“Before rushing to purchase a currency ETF or ETN, it would be useful to evaluate the implicit currency bets that might already be lurking inside your portfolio,” writes Morningstar ETF strategist John Gabriel. “U.S.-based investors who own non-U.S. assets most likely already have sizable exposure to foreign currencies.”

Many financial advisers say U.S. investors should have between 10% and 40% of their portfolios in foreign stocks and bonds. Investors who use U.S.-based mutual funds, for example, invest with dollars, which are then converted to foreign currencies to buy foreign securities. When the fund shares are sold, foreign securities are sold, generating foreign currency that is then converted into dollars.

Changes in exchange rates can boost returns at some times, reduce them at others.

Ideally, a U.S. investor would put money into a foreign stock fund when the dollar is strong, so it will be exchanged for more of the foreign currency, allowing you to buy more foreign shares. And, in a perfect world, you would sell your fund shares when the dollar is weak. That way the foreign currency generated would buy more dollars, increasing your profits.

From the start of 2009 through mid-April 2010, Australian stocks, measured by the MSCI Australia Index, returned about 32%, which was pretty good by anyone’s standards. But because the Australian dollar strengthened against the U.S. dollar, a U.S. investor would have enjoyed a return exceeding 70%, Gabriel writes.

During other periods, exchange-rate changes can work against you. In 2005, British stocks gained 20.1%. But because the dollar strengthened against the pound, U.S. investors gained only 7.4%.

Because exchange rates can have such big effects, it’s important to look carefully at your foreign funds to determine how much of their gains or losses are due to currency swings, which are mainly good or bad luck. A boost from exchange rates can make a fund manager look better than he really is, and vice versa.

Sophisticated investors with a lot of time can hedge against currency changes, but that’s too tough for most small investors. Gabriel points out, however, that most long-term investors shouldn’t worry about it too much. Currency changes are a zero-sum game, with one currency’s gains offset by another’s losses, and the moves swinging back and forth. Over the long term, these swings tend to even out, and your fund’s returns should fairly represent those of the stocks or bonds it owns.

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