Currency Short ETF: Hedging against Exchange Rate Risk
Investing in overseas securities, such as stocks and bonds, may produce significant returns and increase portfolio diversity. However, they bring an additional risk, that of currency exchange rates. Given the substantial impact foreign currency rates may have on portfolio returns, investors should consider hedging this risk whenever possible.
Historically, the only way to profit or protect against currency fluctuations was to trade currency futures, forwards, or options, establish a forex account or buy the currency directly. And these strategies' relative complexity has hampered their broad adoption by the average investor. On the other hand, currency exchange-traded funds are excellent hedging tools for individual investors who want to reduce exchange rate risk.
These currency ETFs offer a more straightforward, highly liquid method to profit from currency movements without the hassle of futures or forex: You buy them in your brokerage account, just as you would any other ETF.
Why Do Currencies Change?
Foreign exchange rates relate to the price at which one currency may trade for another. The exchange rate will rise or fall when the value of one currency changes against another. Economic development, government debt levels, trade balances, and oil and gold prices, among other variables, may all influence a currency's value.
For instance, a country's currency may depreciate versus other currencies due to a decreasing gross domestic product (GDP), increasing government debt, and a massive trade imbalance. Rising oil prices may lead to higher currency levels for nations that are net exporters of oil or have large reserves, such as Canada. A more precise definition of a trade imbalance is when a nation buys much more than it exports. You end up with too many importers dumping their nations' currencies to buy other countries' currencies to pay for all the products they want to bring in.
Exchange Rate Impact on Currency Returns
To demonstrate the impact of currency exchange rates on investment returns, consider the first decade of the new century, a particularly trying period for investors. Investors who limited their portfolios to large-cap United States stocks saw their holdings fall by more than one-third. From January 2000 to May 2009, the S&P 500 Index fell by nearly 40%. Including dividends, the S&P 500 returned roughly -26% or -3.2% annually.
This period saw much better performance in Canada, the United States' largest trading partner. The S&P/TSX Composite Index rose roughly 23%, including dividends, for a total return of 49.7% or 4.4% annually. The Canadian S&P/TSX Composite Index outperformed the S&P 500 by 75.7% cumulatively or 7.5% annually.
The Canadian dollar's 33% rise against the greenback boosted returns for United States investors who invested in the Canadian market during this period. In United States dollars, the S&P/TSX Composite gained 63.2%, for a total return of 98.3%, or 7.5% annually. That's a represents 124.3% gain above the S&P 500.
In other words, $10,000 invested in the S&P 500 in January 2000 would have to dwindle to $7,400 by May 2009, whereas $10,000 invested in the S&P/TSX Composite would have almost quadrupled to $19,830.
During the first decade of the twenty-first period, American investors benefited from a lower dollar, which was in long-term or secular decline. Investors held assets in a depreciating (foreign) currency, hedging exchange risk was not advantageous. However, a falling currency may reduce good returns or amplify negative returns. From January 2000 to May 2009, Canadian investors in the S&P 500 had returns of -44.1% in Canadian dollars (against -26% in USDs), as their investments depreciated (the USD, in this case).
Consider the S&P/TSX Composite's performance in the second half of 2008. During this period, the index dropped 38%, one of the worst results in global stock markets, as commodities prices collapsed and all asset classes declined. During this period, the Canadian dollar lost nearly 20% against the USD. During this period, an American investor in Canada would have earned -58% (excluding dividends for simplicity). In this case, an investor could have invested in Canadian stocks while reducing trading risk by using currency ETFs.
3 ETFs to Profit from a Weakening Dollar
While Bitcoin has dominated late news about currency movements, the United States dollar has also made a sizable shift lately. While the greenback has not moved in the triple digits like its digital cousin, it has fallen 2.4% versus a basket of the world's primary currencies since May 23, a substantial decline for a safe-haven currency.
Over the last month, the dollar has been under pressure due to indications that the Federal Reserve would reduce interest rates several times. The Federal Reserve indicated last week at its policy meeting that it was prepared to cut rates to counter sluggish domestic growth and stagnant inflation. Markets for federal funds futures are pricing in a half-point reduction this year and another 40 basis points in 2020. Indeed, according to the CME Group's FedWatch website, the futures market anticipates a 78.1% probability of a 25 basis point reduction at the Fed meeting next month.
According to analysts, declining United States bond rates and negative technical indications may add to the dollar's challenges in the months ahead. "This still has legs," said Paresh Upadhyaya, director of the currency strategy at Amundi Pioneer Investments in Boston. Those interested in shorting the dollar but not opening a foreign exchange account may explore the three currency exchange-traded funds (ETFs) mentioned below. Let's take a closer look at the specifics of each fund and use technical analysis to identify potential trading opportunities.
Bearish Invesco DB USD Index Fund (UDN)
Invesco DB USD Index Bearish Fund (UDN) was launched in 2007 to replicate the performance of the Deutsche Bank Short USD Index Futures Index. The tracked benchmark index tracks changes in the euro, Swiss franc, Japanese yen, British pound, Swedish krona, and Canadian dollar's value with the USD. UDN invests 57.50% of its assets in the euro, making it especially vulnerable to currency movements. Traders will enjoy the fund's ultra-narrow 0.05% and daily dollar volume liquidity of more than $700,000. As of June 27, 2019, the fund has $32.94 million in assets under management (AUM), paid a 0.75% management fee, and had gained 1.70% the previous month. Additionally, investors get a 1.29% dividend return.
In late May, the UDN chart showed indicators of fading selling momentum as the share price produced a lower low, but the relative strength index formed a shallower low, forming a positive divergence. The fund's price broke above a long-term downtrend line in early June, continuing to rise throughout the month to trade above the 200-day simple moving average (SMA). Traders buying here should place a stop-loss order below the June 20 gap and attempt to profit from a rise to the September swing high of $21.55.
CurrencyShares Euro Currency Trust, Invesco (FXE)
The Invesco CurrencyShares Euro Currency Trust (FXE), established in December 2005, follows the euro's value relative to the US dollar. The fund invests in virtual euros, enabling it to closely track the performance of the euro/dollar exchange rate. Traders should be warned that the fund's actual euro deposits are not guaranteed, leaving shareholders exposed to default risk directly. FXE has plenty of liquidity, trading over 200,000 shares each day with a 0.01% average spread. As of June 27, 2019, FXE was trading at $108.19, with net assets of $249.42 million and an expense ratio of 0.40%.
With UDN's substantial exposure to the euro, it's unsurprising that FXE's chart resembles UDN's. After breaking above a strong downtrend line and the 50-day simple moving average earlier this month, the price retraced to those indications, providing support for a push into the 200-day simple moving average. Traders may either buy now or wait for a convincing closing above the long-term moving average, which has served as resistance at this price. Consider placing a take-profit order around the 52-week high of $113.14 and reducing losses if the fund's price falls below the doji candlestick low of $107.30 on June 20.
CurrencyShares Canadian Dollar Trust, Invesco (FXC)
The Invesco CurrencyShares Canadian Dollar Trust (FXC) seeks to track the Canadian dollar's exchange rate movements versus the US dollar. The fund, which rebalances quarterly, offers direct exposure to the Canadian currency, often referred to as the loonie, by keeping real Canadian dollars in a deposit account with JPMorgan Chase & Co. (JPM). A razor-thin spread of 0.03%, coupled with daily dollar volume liquidity over $2 million, minimizes slippage and enables traders to capitalize on minor price movements.
While not ultra-cheap, the fund's 0.40% cost ratio remains competitive for investors looking to hold for more periods. FXC has a market capitalization of $118.64 million, a dividend yield of 0.66%, and has increased by 1.99% in the last month. As of June 27, 2019, the fund has returned almost 4% year to date. FXC shares surged in January before grinding sideways for the following four months. Sentiment shifted in early June when the price gapped above both an early-2018 downtrend line and the 200-day SMA.
The funds maintain their upward momentum, except for a minor pullback in the middle of the month, indicating the emergence of a new uptrend. Because it may be the start of a rally, traders may choose to sell half of their holdings around the October swing high of $76.75 and the remaining 50% near the 2018 high of $79.85.
Currency Exchange-Traded Funds (ETF)
The currency ETFs enable you to invest in foreign currencies just as you can in stocks or bonds. These products mimic the currency's movements in the foreign exchange market by holding currency cash deposits in the tracked or by trading futures contracts on the underlying currency. In any case, these strategies should provide a highly linked return with the currency's actual movements over time. These funds generally have minimal management costs due to the low level of management required. It is always prudent to check the fees before buying.
There are many currency ETFs available on the market. You may buy exchange-traded funds (ETFs) that follow certain currencies. For instance, the CurrencyShares Swiss Franc Trust tracks the Swiss franc (NYSE: FXF). If you believe the Swiss franc is set to strengthen versus the USD, you may want to buy this ETF; if you believe the Swiss currency is set to weaken, you may want to sell it short.
Additionally, you may invest in ETFs that follow a basket of various currencies. For example, the Invesco DB USD Index Bullish and Bearish ETFs (UUP and UDN) monitor the performance of the US dollar versus the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. Currency exchange-traded funds (ETFs) use even more active currency tactics, most notably the DB G10 Currency Harvest Fund (DVB), which follows the Deutsche Bank G10 Currency Futures Harvest Index.
This index capitalizes on yield spreads by buying futures contracts in the G10's top-yielding currencies and selling futures in the G10's three lowest-yielding currencies. In general, similar to other ETFs, when you sell an ETF, you will make a profit if the foreign currency has gained versus the dollar. On the other side, if the currency or underlying index of the ETF has declined in value compared to the dollar, you would incur a loss.
Currency ETF Hedging
Consider a hypothetical investor in the United States who invested $10,000 in Canadian stocks through the iShares MSCI Canada Index Fund (EWC). This ETF aims to replicate the performance of the Canadian stock market, as measured by the MSCI Canada index, in terms of price and yield. At the ETF's end-of-June 2008 price of $33.16 a share, an investor with $10,000 would have bought 301.5 shares (excluding brokerage fees and commissions).
This investor would have sold short currency shares in the CurrencyShares Canadian Dollar Trust if they wished to hedge against currency risk (FXC). This ETF tracks the Canadian dollar's price in US dollars. In other words, when the Canadian currency strengthens versus the US dollar, FXC shares strengthen. Think about an investor who believes the Canadian currency will rise and chooses not to hedge or "double-up" on Canadian dollar exposure by buying (or "going long") FXC shares.
In this case, the investor sought to hedge currency risk. It would have been smart to "short sell" the FXC units. To hedge $10,000 in EWC units, the investor would short sell 100 FXC shares and buy them back later at a lower price. By the end of 2008, EWC's stock had fallen to $17.43, a 47.4% decline from its acquisition price.
A portion of this decline in the share price may be ascribed to the Canadian dollar's decline against the USD during this period. The hedged investor would have countered some of this loss with again on the short FXC position. Without hedges, the unhedged investor would have lost $4,743 on his original $10,000 investment in EWC shares. On the other hand, the hedged investor would have suffered a portfolio loss of $2,943.
Some investors may believe it is unprofitable to hedge each dollar of overseas investment with a currency ETF. However, since currency ETFs are marginable, this barrier may be circumvented by utilizing margin accounts (brokerage accounts in which the brokerage loans the customers with a portion of the money for investment) for both the overseas investment and the currency ETF.
An investor with a set amount to invest and a desire to hedge exchange risk may invest with a 50% margin and utilize the remaining 50% to buy a currency ETF. Notably, investing on margin entails the use of leverage, and investors should be aware of the dangers associated with leveraged investment methods.
Currency movements are unexpected, and they may harm portfolio returns. For instance, during the first quarter of 2009, the USD surprisingly gained versus most global currencies, despite the worst financial crisis in decades. During this period, these currency movements exacerbated negative returns on foreign assets for US investors.
Hedging foreign trading risk is a prudent strategy to use during times of exceptional currency volatility. Currency ETFs are excellent hedging tools for individual investors to manage trading risk due to their investor-friendly characteristics. For more trading information and more details of currency ETF, please visit and check out Instaforex. Happy Trading Traders!
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