The Hottest Trade of 2006

Now, years later, the deutsche mark is gone, replaced by a single European currency used by 400 million people in 22 countries. The euro is the world's most liquid and actively traded currency behind the U.S. dollar. It's also the benchmark for a new New York Stock Exchange-listed security that I believe is poised to become a huge success.

Three years ago, I heralded the launch of fixed-income exchange-traded funds as a major breakthrough. More recently, I covered gold ETFs as a huge development in portfolio opportunity. Last week, Rydex Investments introduced the Euro Currency Trust (FXE), a currency-based ETF that trades on the NYSE. Although only recently launched, this landmark innovation represents a major victory for capital-market participants world-wide. That's why it gets my vote as perhaps the best trade of the new year.

Simply put, this new ETF offers an effortless way to bet on (or against) the euro. Trading under ticker symbol FXE, each share represents 100 euros plus accrued interest. If the euro strengthens relative to the U.S. dollar, then the price of FXE will rise. If the euro weakens, then FXE falls. Because euros held in the fund earn interest, the fund also boasts a dividend (although a portion of the yield will be lost to the 0.4% annual fee paid by investors to the fund's sponsor, Rydex). The ETF can be sold short or bought on margin, with investors paying a brokerage commission to trade it just like any other similar security. Both the prospectus and fact sheet are worth reviewing.

The opening up of foreign exchange to individual investors represents a landmark achievement. The forex market is huge, trading more than $1.8 trillion each day with a quarter of that occurring between the dollar and euro. Yet unlike equities, forex trading occurs "over the counter" with no centralized marketplace. Most transactions range between $5 million and $50 million, making it impossible for all but the biggest players to participate. Spreads and commissions in the opaque "spot" market are also difficult obstacles to profitably overcome.

Currency futures, while exchange traded and more readily accessible to the retail customer, present their own shortcomings, including the need to constantly roll positions forward as contracts expire. FXE, on the other hand, trades on the NYSE and never expires, so it can be held for as long as a trader's capital allows.

Like the gold and fixed-income ETFs, FXE democratizes an entire asset class that, for the average investor, was almost impossible to directly participate in. In recent years, foreign-bond funds like Templeton Global Income (GIM) and American Century International Bond (BEGBX) have become popular ways to play a weakening U.S. dollar, although those funds presented additional exposures in the forms of credit and interest-rate risk. FXE offers a "pure play" on the euro and makes getting specific exposure as easy as buying shares in General Electric (GE).

Most of us are familiar with the need to diversify our equity and fixed-income portfolios. Yet the difficulty in playing the dollar has kept us from having to think too much about currency risk — the potential that the value of the dollars in your pocket (or bank account) might fall in value relative to other world currencies. And while there are thousands and thousands of mutual funds that own the same handful of large-cap U.S. stocks, this is one of the few products that allows individual investors to diversify into an entire new asset class.

As I wrote a while back, more than stocks, bonds or any other asset, Americans live, think and breathe in dollars. We hold them in our pockets, and in savings and checking accounts. Our paychecks and bills are paid in dollars. So regardless of your view on the economy or President Bush, most of us are "long" dollars in a big way. This new ETF offers an efficient and easy way to diversify that risk.

For the more active investor, I predict the security will likely become a major trading vehicle. It's already off to a busy start, averaging roughly 400,000 shares traded a day. Even more notable, the market has been incredibly liquid, with five- to 10-cent spreads and markets 50,000 shares deep. If you ask me, it won't be long before FXE, not unlike StreetTracks Gold Shares (GLD), will be routinely trading a million shares a day.

Although it has recently weakened, much to Warren Buffett's dismay, the U.S. dollar mounted a strong recovery against the euro in 2005. (One euro currently equals about $1.20.) Regardless of what 2006 has in store, I believe FXE is on the road to becoming the first of a series of widely successful currency-linked ETFs. Unlike the dozens of copy-cat funds mirroring large-cap benchmarks, the security presents investors of every size an effortless entry into a particularly important yet cumbersome corner of the capital market. It is certainly a ticker to watch in the year ahead.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in some of the securities mentioned in this article.