For ETF Investors, Currency Exposure Matters

by: Michael Johnston

By Stoyan Bojinov

Equity markets have taken investors for a wild ride over the past three months with chaotic trading dominating virtually every nook and corner of Wall Street. Amid the volatility, investors have been seeking out refuge and fleeing to “safer” asset classes. Although rational, this approach inevitability overlooks certain corners of the market that may in fact be a lot less riskier than most investors might think. Currency exposure in particular is often times overlooked, especially when stock markets are unfriendly, due to preconceived notions about the risks and rewards associated with this misunderstood asset class.

When picking an ETF investment, many advisors don’t give a whole lot of thought to currency exposure, often times deeming it as far too risky or complex for their portfolio’s needs. In fact, many investors may not have a strong opinion on the Brazilian real, Japanese yuan, or the Australian dollar. But those same investors often have exposure to those currencies - whether they realize it or not - through investments in assets denominated in those currencies.

Exposure to exchange rates is not reserved for those trading in ultra-leveraged forex accounts. The reality is that the vast majority of investors maintain significant exposure to international currencies in their portfolios through international stocks. Going long in Brazilian equities, for example, inherently includes a long position in the Brazilian real relative to the U.S. dollar. If the Brazilian currency appreciates, the returns realized by U.S. investors will be enhanced and vice versa (more on this below).

Decisions on whether to accept risks associated with currency exposure can be big ones, as exchange rate movements can potentially have a huge impact on bottom line risk/return profiles. Below we highlight three noteworthy examples that demonstrate the impact of currency exposure on ETs:

1. ELD vs. EMB

When it comes to emerging markets exposure, many investors have embraced the exchange-traded product structure as a preferred means of rounding out exposure to both the equity and debt markets of developing nations. When comparing two popular offerings from the Emerging Markets Bonds ETFdb Category, the WisdomTree Emerging Markets Local Debt Fund (NYSEARCA:ELD) and the iShares JPMorgan Emerging Bond (NYSEARCA:EMB) appear almost identical after a quick glance.

Both products feature a similar split between foreign government debt and corporate bonds, and similar debt issues are even found in both of the fund’s top holdings. However, there is a a key difference between these products, and it has a rather significant impact on bottom line returns. ELD’s debt holdings are denominated in the local currency of the issuers, while EMB provides exposure to U.S. dollar denominated emerging markets debt. Consider their year-to-date performances (as of 10/29/2011): ELD is down about 4%, while EMB is up about 1%. This difference in returns is largely attributed to the fact that the U.S. dollar has appreciated quite a bit over the last few months as investors have sought out this safe haven currency amidst the market turmoil.

2. DBBR vs. EWZ

Fluctuations across foreign exchange rates can have a material impact on international products which have currency exposure. Consider for example the popular iShares MSCI Brazil Index Fund (NYSEARCA:EWZ), which provides exposure to the performance of the Brazilian equity market, versus the recently launched MSCI Brazil Currency-Hedged Equity Fund (NYSEARCA:DBBR):

Click to enlarge

In the table above, notice the performance differences between the two. This variation in returns is quite significant when we consider the fact that DBBR provides exposure to the exact same basket of securities as EWZ. The distinguishing feature, however, is that DBBR is designed to provide exposure to Brazilian equity markets, while at the same time mitigating exposure to fluctuations between the value of the U.S. dollar and Brazilian real. The vast difference in performance between DBBR and EWZ across different time periods demonstrates the potentially adverse effects of currency fluctuations.

3. Pure Currency ETFs With Stellar Returns

Many investors shy away from currency investing, influenced by perceptions of extreme volatility and a zero-sum game. While ultra-leveraged forex trading does introduce potential for significant fluctuations - and likely losses after fees are considered - investors with a keen eye for spotting trends in macroeconomic developments can certainly stand to benefit from currency ETFs.

Two ETFs from the Currency ETFdb Category have delivered some stellar returns over the last five years, leaving popular stock and bond products in their dust:

Ticker ETF 5-Year Gain (Loss)
FXA CurrencyShares Australian Dollar Trust 66.1%
FXF CurrencyShares Swiss Franc Trust 42.6%
SPY SPDR S&P 500 -1.3%
EEM MSCI Emerging Index Fund 19.5%
AGG Barclays Aggregate Bond Fund 35.4%
As of 10/21/2011

Consider the five year returns for the Australian dollar and Swiss franc versus three popular broad-based benchmarks in the table above. The impressive returns of FXA and FXF dwarf the performances of both domestic and international equities, even surpassing a popular bond market benchmark. While there's no guarantee that the Aussie dollar will continue its stellar uptrend for five more years, it’s most certainly worth noting that currency investing can potentially enhance your portfolio’s bottom line returns over the long haul.

Disclosure: No positions at time of writing.


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