Dealing in Currency ETFs

While significant market movements are an opportunity for traders in the forex market, other long-term investors dislike high market volatility because of the risk that it poses. They have a relatively straightforward goal – to generate reasonable long-term profits while minimizing risk. Because of this, diversification is a key part of their portfolio strategy. The idea behind diversification is that while particular market events and global socioeconomic trends can damage individual equities – or even entire market sectors – the same events or trends will have a positive effect on other equities, offsetting losses. For example, bonds are often a good hedge against stock market declines.

In fact, stock investors are increasingly using currencies to hedge against risks with their stock portfolios. However, the problem with doing this is they have to manage their currency and stock investments separately, making this sort of diversification difficult to handle. New currency exchange-traded funds (ETFs) eliminate this problem. With a currency ETF, an ETF management firm buys currency pairs and holds them in a fund. The firm then sells shares in the ETF to individual investors, who can then buy and sell them in just the way that they buy and sell stocks. As the currency pair arises, the corresponding share price rises in tandem, and the share price falls as the currency falls.  

To understand why investors are interested in using currencies rather than just buying other shares, it is important to know the different types of risk in the stock market. The first is what is known as idiosyncratic risk – the risk that any particular stock will fall. For instance, if a company reports poor results, the stock price will typically fall, even if its competitors are doing well. This type of risk can be managed by buying a broader basket of stocks. However, there is also systematic risk – the risk that the entire stock market will fall. You only need to look at the initial effects of the recent world economic crisis to see this type of risk in action.  

Buying a broader range of stocks doesn’t combat systemic risk. However, investing in currencies can do exactly this. For example, consider the Swiss franc. In general, history has shown that the Swiss franc rises against the US dollar when bond yields fall. Since falling bond yields generally happen when the stock market falls, holding a position in CHF/USD can hedge against the risk of a bear market. Similarly, the Canadian dollar tends to rise as oil prices rise, since Canada is a major oil producer. Because of this, investing in a CAD/USD ETF can be used to hedge against the impact of higher energy prices on the stock market.

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