While the products require sophisticated knowledge, there are certain situations where they can be worth the trouble
Some investors, in an effort to rid themselves of home bias, may be intrigued by the idea of investing in currency mutual or exchange-traded funds. Reportedly averaging more than US$5 trillion in trading volume daily, the foreign-exchange market is the world’s biggest financial market, which could be tempting for investors to get exposure to.
But investment experts caution that these funds are typically more appropriate for investors with a strong grasp of the currency markets. As noted in The Wall Street Journal, foreign exchange rates can turn on many factors. While interest rates and monetary policy top the list, one must also watch for potential impacts from trade and other pieces of economic policy; global developments on financial, political, and military fronts; and market sentiment, among other things.
Currency funds can either be single-currency or multicurrency products, with many investing in high-quality money-market instruments denominated in the target currency or currencies. Certain strategies also include currency forward contracts and currency swaps, which further complicate things.
Such funds are not cheap, said Morningstar analyst Tayfun Icten, who studies currency funds. The firm has data on 45 open-end currency funds, including 34 ETFs and 11 mutual funds. The ETFs come with average expenses of 0.74% of assets annually, while the mutual funds have an average of 1.33%.
They have also generally generated measly returns in recent years, Icten added, amid narrow interest-rate differentials and emerging-market volatility that have persisted since the 2008 financial crisis. Based on a record of 45 open-end currency mutual funds and ETFs tracked by Morningstar, which have combined assets of US$5.9 billion, such funds have averaged annual returns of -0.63% for one year, 0.22% for three years, -0.94% for five years, and -0.16% for 10 years as of April 30.
Icten says currency-fund investors often end up “paying fees for an investment that will go nowhere.” But he and others acknowledge evidence of two types of currency investments that can, at times, be profitable. Momentum trades, which represent bets that a currency will continue to move in a particular direction, paid off for those who put money on the dollar sustaining an upward trend against major currencies from mid-2014 through late 2015. Icten noted, however, that the dollar has been contained in a range since then.
Carry trades, on the other hand, are a complex form of arbitrage. They involve borrowing a currency from a country with low interest rates, and using it to finance the purchase of second currency earning a higher interest rate. The trader can then invest the second currency in interest-bearing instruments to benefit from the higher rates, in hopes that the second currency will rise against the first. It can be a useful way of diversifying long equity and bond risk while capturing some premium in the long term, according to Chris Geczy, academic director of the University of Pennsylvania’s Wharton Wealth Management Initiative. But this diversification can disappear during certain times of stress when stocks, bonds, and currency all tumble in sync.
While currency funds can also be theoretically used to hedge the currency exposure of a foreign stock or bond fund, many experts warn that determining what hedges are needed and to what degrees is too difficult, particularly for multi-country funds that change their holdings frequently. With trading costs added to the equation, most investors will find that trying to keep up the hedge would be too expensive.