From the February 2007 issue of Research Magazine • Subscribe!

Taking Clients Beyond Stocks and Bonds

Pressure on the U.S. dollar has been considerable. Late last year, the greenback touched 14-year lows versus the British pound, sparking worries that the worst is yet to come amid slowing GDP, rising government debt and a whopping trade gap. As a result, some investors holding dollars and dollar-denominated securities are looking for ways to hedge against further declines. Is currency trading the answer?

Foreign exchange markets have been made to look somewhat glamorous by successful speculators like George Soros, who is famous for making big bets like his $10 billion wager that the British pound would collapse in 1992. In a single day, he reaped a $1 billion windfall and became an investing legend. Still, it's fair to say that when it comes to currency investing, Soros is the exception, not the rule. Most currency investors, no matter how skilled, will never match his success.

How can investors who aren't George Soros get exposure to currency markets?

Currency-linked ETFs

For mainstream investors, sophisticated currency strategies, while sexy, are easier discussed than executed. But the emergence of currency-linked trusts, which are categorized as ETFs, may change that. Rydex Investments manages a series of seven trusts that aim to track the movement of various countries' currencies. Known as CurrencyShares, the oldest member of this family is the Euro Currency Trust (NYSE: FXE), which has amassed just under $1 billion of assets.

"This appeals more to retail investors than the futures market because there's less leverage built into the product," says Mike Mills, president of Mike Mills Wealth Management, in Southlake, Texas. "That being said, this is more geared for a trading or hedging strategy versus a long-term core position."

Unlike traditional ETFs, which are registered under the Investment Company Act of 1940, CurrencyShares are grantor trusts governed under the Securities Act of 1933. They're created and redeemed in each respective foreign currency and don't use any leverage or derivatives. The actual currency is deposited within each trust and held at a secure depository managed by the London branch of JPMorgan Chase Bank.

Another feature that distinguishes CurrencyShares from traditional ETFs is that these investments do not follow a benchmark index or have a portfolio manager. Rather, they're designed to imitate the price of the underlying currency according to the Federal Reserve noon buying rate.

CurrencyShares also provide interest in the form of a yield based upon overnight interest rates in the country that issues the underlying currency. CurrencyShares with high yields as of late December 2006 included the Mexican Peso Trust (6.40 percent), the Australian Dollar Trust (5.78 percent) and the British Pound Sterling Trust (4.70 percent).

When it comes to taxes, income is flowed through to each shareholder as if they owned a pro rata share of the currency assets held by a particular trust.

While the architecture of the CurrencyShares is considerably different from traditional ETFs, they still trade in a similar fashion. They can be purchased with market, stop or limit orders, and can also be shorted. Furthermore, by making currency exposure possible in a traditional brokerage account, these products eliminate the hassle of having to establish a currency trading or futures account for your clients.

Another possible play for the currency-minded investor is the PowerShares DB G10 Currency Harvest Fund (Amex: DBV), which takes a more active approach by using long and short strategies. The ETF aims to be long on the three currencies in its universe with the highest yield, while being simultaneously short on the three with the lowest yields. The index is managed by Deutsche Bank and selects from a universe of currencies that consist of G10 nations.

The Best Way To Hedge

As a refresher, foreign exchange rates refer to the price at which one currency can be exchanged for another. For example, the higher the exchange rate for one euro in terms of one dollar, the lower the relative value of the dollar. As of late 2006, one dollar was convertible into 0.76513 euros. This was good for holders of the European currency, who received greater purchasing power over the dollar. Reflecting that strength, the Rydex Euro Trust posted a gain of 13.02 percent through the end of December.

As good as they may seem, not everyone's convinced that currency-linked ETFs are the best way to hedge against a declining U.S. dollar.

"I don't see the need to use them in client portfolios," says Herb Morgan, president and CEO of Efficient Market Advisors in San Diego. "As a trading vehicle, they probably don't even offer enough liquidity, and people that really want to trade currencies are using the futures or forex markets."

Others argue that emerging market and international stock funds are more effective at offsetting any weakness in the U.S. dollar. However, Tim Meyer, product development manager at Rydex, disagrees: "Based upon our research, international stocks and the S&P 500 are highly correlated -- roughly 70 percent. In contrast, currencies (as measured by the U.S. dollar index) have a very low correlation to the S&P."

Connecting The Performance Dots

Currency exchange rate fluctuations affect the performance returns of investments denominated in those currencies. From 1995 to 2001, a surging domestic stock market coincided with a strong U.S. dollar. It was also during this time frame that domestic stocks outperformed foreign equities. The opposite happened from 2001 to 2004; As the dollar slid in value, the performance of domestic stocks followed suit.

All of this underscores the effect of currency movements. To invest in foreign securities, whether directly in stocks or via an international mutual fund or ETF, U.S. investors have to convert their dollars into a foreign currency. As that currency gains or loses value relative to the dollar, it impacts the gain or loss on the investment.

In some cases, those gains or losses can be magnified. In 2006, for example, the strength of overseas currencies coupled with a weakening dollar contributed to significant foreign stock market gains. As a widely followed benchmark of international stocks, the MSCI EAFE index gained 13 percent last year when measured in local currency terms. However, when translated into dollars, the returns were magnified to 23 percent, or almost double.

"The immediate effect of a decline in the dollar is a boost in the value of foreign-currency denominated assets such as international stocks in dollar terms", notes Brian Gendreau, Ph.D., investment strategist at ING Investment Management.

The Forgotten Asset Class?

The traditional view of currencies has been that this is not a distinct asset class so much as a niche or specialized type of investing. But could that opinion change? Bilal Hafeez, the global head of foreign exchange strategy at Deutsche Bank, thinks so.

In a research report published in the summer of 2006, he argued currencies should represent a greater portion of investors' portfolios. As he put it, "We feel that foreign exchange should be viewed as an asset class similar to bonds and equities. It has exhibited long-term systematic returns or 'beta' that are comparable, if not better than, both bonds and equities since 1980. It also has greater liquidity than both."

Even though the tone of Hafeez's research was geared to institutional investors, financial advisors and retail investors might want to take note.

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Ron DeLegge is editor of www.etfguide.com.

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