As the dollar continues its fall against other world currencies, it makes imports and foreign travel more expensive for Americans. But some investors have cashed in on the trend -- by investing in mutual funds and ETFs that trade in currencies.
Currency exchange-traded funds and mutual funds -- all of which bet on the dollar's movement against one or more currencies -- are growing quickly, though still a niche product. In the first seven months of the year, they took in nearly $2.8 billion in new cash from investors, sending their assets up 37% from the year before, according to Morningstar Inc.
Most of these funds bet against the dollar, which fell 6.2% this year, through August, against a broad basket of currencies including the euro, the Japanese yen and the Swiss franc.
Michael Rawson, an ETF analyst with Morningstar, says currency funds will likely keep gaining popularity, since many signs point to the dollar continuing its decline. Global demand for the dollar is likely to keep waning as U.S. interest rates stay low and large federal budget and trade deficits continue to raise questions about U.S. fiscal health, Mr. Rawson says. Emerging nations that once used dollars when trading with one another, meanwhile, are increasingly using their own currencies to trade.
But while currency funds may seem like a solid play on a stark economic trend, experts say investors looking to benefit from the dollar's decline need to pick a fund carefully because they can be volatile and some have unusual structures. Moreover, you may already have plenty of exposure to foreign currencies through funds that hold international stocks and bonds.
Here are some things for potential investors in currency funds to consider:
What type of bet do you want to make?
Currency funds are very different from stock or bond funds. You are not investing in a company and may not earn interest. Returns mostly depend on currency swings. Relative values of currencies can zig and zig unpredictably over short periods.
Limit your risk by investing broadly. "If you're starting currencies, you're probably better off getting a broad, diversified basket than picking a small, individual country," says Luciano Siracusano, chief investment strategist at WisdomTree, an investment company that sells a variety of currency ETFs.
Funds that buy and sell multiple currencies tend to make lots of different bets in hopes that the total balance of the trades will be in the fund's favor. They sometimes use bonds and other fixed-income investments to make those bets. With many traders predicting the dollar will fall further, some funds that invest in a broad basket of currencies also have the advantage of being able to invest more in currencies they think will rise against the dollar.
By contrast, single-country currency funds can provide the biggest returns -- and losses. This year's big gainer: CurrencyShares Swiss Franc Trust (FXF),
But the biggest currency-fund losers in 2011 have bet on the dollar: PowerShares DB U.S. Dollar Index Bullish (UUP)
Andrew Feldman, a financial adviser in Chicago, uses broad currency funds like the WisdomTree Dreyfus Emerging Currency (CEW)
"For long-term investors, I absolutely stay away from any single-country currencies," he says. Currency funds generally make up less than 2% of a client's portfolio.
How does the currency fund work -- and what does that mean for returns?
The financial nuts and bolts of currency funds vary -- and often have an impact on returns. Some funds, like CurrencyShares Swiss Franc Trust, one of the largest currency ETFs by assets, work by holding that physical currency. Thus, your return will be pretty close to the change between the spot price of the Swiss franc against the dollar.
Other funds give you exposure to foreign money-market rates through a complex set of financial instruments. That means your return will also factor in the interest rate being offered for a short-term deposit internationally. So you may earn more than the change in spot rates, especially in countries with high interest rates, like Brazil. WisdomTree Dreyfus Brazilian Real (BZF)
China is a special case for would-be currency investors. The Chinese currency is tightly controlled by the central government, so investors may be able to anticipate how much the central bank is going to allow it to appreciate against the dollar over a period of time. That anticipated increase is often priced into the forward contracts that some funds, like WisdomTree Dreyfus Chinese Yuan (CYB),
Be sure to ask about the structure and tax consequences of currency funds. Some ETFs act as trusts or limited partnerships, with different tax treatment than conventional funds.
Would a foreign stock or bond fund be better?
International equity and bond funds with good track records can give investors currency exposure. Since a foreign bond's price or a foreign company's earnings are typically based in its local currency, investors in international equity and bond funds benefit if the currency gains against the dollar, says Mr. Rawson of Morningstar.
Financial adviser Jason Gunkel in West Des Moines, Iowa, says "currency funds aren't a bad thing." But at his firm, Syverson Strege & Co., "we think we can get exposure to the currency using stock and bond funds." Before buying, he makes sure the funds aren't hedged to the U.S. dollar, so his clients get the full benefit of any foreign-currency appreciation. Some international funds hedge against rises and falls in the dollar.
One benefit of a currency fund, as opposed to an international equity or bond fund: portfolio diversification. Currency funds can provide a cushion in the event of broad downdrafts in equity or bond markets.
"The returns you generate will have a very low correlation with other parts of the portfolio," says Axel Merk, the chief investment officer of Merk Investments LLC, Palo Alto, Calif., which manages three currency funds. The firm's flagship Merk Hard Currency
If you are worried that interest rates will rise, driving bond prices lower, you might prefer a currency fund to one that holds longer-term bonds. An investor interested in emerging markets might consider WisdomTree Dreyfus Emerging Currency and WisdomTree Emerging Markets Local Debt (ELD),
Ms. Ensign is a staff reporter for The Wall Street Journal in New York. Contact her by email at firstname.lastname@example.org.