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Smarter Ways to Make Currency Plays

You don't have to be George Soros: New ETFs and other instruments allow smaller investors to participate in the movements of the dollar, euro, and yen

By David Bogoslaw,

Currencies? Aren't they just for the big-money, no-fear types like George Soros—or the institutional players with powerful computer models at their disposal?

Not exactly. While in the past, investments linked to movements in the currencies of the world's leading economies have been viewed as too risky or too complicated for smaller investors, fund companies are starting to offer exchange-traded funds (ETFs) and other vehicles that make currency plays available to the little guy at affordable prices.

These new products come at an interesting time; investing in foreign currencies is a much trickier proposition than it was just a couple of months ago. The dollar has lately been showing some strength against the euro and other selected currencies, buoyed by successive rate cuts by the Federal Reserve and speculation an economic recovery may be speedier in the U.S. than in Europe.

Indeed, currency vehicles have been introduced and are grabbing greater attention at a time when the U.S. dollar has been trading at record lows against currencies including the euro, and they are likely to continue to attract interest from investors who are more and more concerned with reducing their exposure to U.S. equities and Treasury bonds.

Long-Term Considerations

Rydex Investments now offers eight CurrencyShare ETFs, structured as grantor trusts that hold the underlying currency and gain or lose value based on exchange rates and any overnight interest that accrues. The CurrencyShares Euro Trust (FXE) was rolled out just over two years ago and now has just under $1 billion in assets under management. The CurrencyShares Japanese Yen Trust (FXY), whose shares each represent about 10,000 yen has grown much more rapidly. The yen trust already has more than $1 billion in assets under management and marks its first anniversary later this month.

"We think this is timely. We've had a lot of success with [these ETFs]," says David Reilly, director of portfolio strategy at Rydex. "With the dollar being kind of in the spotlight, this has been one of the few vehicles investors can go to, to introduce currency exposure into their portfolios" and is desirable for its low volatility and low portfolio correlation characteristics.

The creators of these products for the most part say they are more motivated by long-term goals of helping investors more effectively structure their portfolios rather than short-term trends in the currencies markets. Even E*Trade Financial (ETFC), which markets to online investors and widely launched its multicurrency global trading platform with access to six markets last July, says it's positioning itself for what it sees as longer-term portfolio shifts to international markets.

"People tend to think of foreign exchange and currencies as highly volatile, very short-term in nature, and an arena for the very sophisticated sort of trader," says Reilly. "We saw the opposite. When you look at them over time, they tend to be relatively low return, with low volatility, more like fixed income than equities."

That, plus the realization that retail investors had no efficient way to get exposure to currencies if they had a particular view on them, convinced Rydex to create the CurrencyShare ETFs.

ETNs vs. ETFs

An alternative way to invest in foreign currencies is through the iPath products offered by Barclays. These exchange-traded notes (ETNs) track the value of specific currencies and are treated as debt, which you can either hold 30 years until maturity or redeem at some earlier point. ETNs may be less attractive as the result of a December ruling by the Internal Revenue Service that said all single-currency instruments such as ETNs should be taxed as debt, and that gains from both interest income and currency appreciation will be taxed at regular income rates of up to 35% instead of being taxed as capital gains, at a maximum 15% rate.

The fact that international markets have outperformed domestic ones for the past few years has made it easier to market these currency products, says Carmine D'Avino, a certified financial planner at Pinnacle Associates in New York.

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