Currency Trading For the Little Guy

Currency trading used to be a strategy employed by only the wealthiest investors and hedge funds, but a growing number of mutual and exchange traded funds make it possible for individuals to try it for themselves, with significantly smaller amounts of money.

In the past, if you wanted to trade currencies, you'd need thousands of dollars to establish even a minimal position using futures contracts, said Jim King, director of portfolio management at Rydex Investments. Now, do-it-yourselfers can get exposure through funds for a lot less -- as little as $1,000, depending on the minimums required by your fund supermarket.

The Rydex Strengthening Dollar Fund (RYSBX) and the Weakening Dollar Fund (RYWBX), launched last May, along with the first currency exchange traded fund, the Euro Currency Trust (FXE), launched in December, allow regular folks to speculate on the direction of the dollar or hedge currency exposure in portfolios heavy in foreign stocks.

In effect, this is "bringing a hedge-fund-type strategy to the common man," King said.

"A theme here at Rydex is giving people stuff they couldn't do on their own in a mutual fund wrapper," King said. "And currency trading is kind of the granddaddy of them all, it's the epitome of what hedge funds love to do, and it's something that people have trouble doing on their own."

The question is, does the common investor really need to be messing around with hedge-fund strategies? Some experts are skeptical about whether such funds are necessary in the average person's portfolio, particularly if it's well diversified with adequate exposure to international equities. Furthermore, the 1.7 percent expense ratio Rydex charges for its strengthening and weakening dollar mutual funds makes them an expensive gamble, said Richard A. Ferri, president of Portfolio Solutions in Troy, Mich., and author of "All About Asset Allocation" and other books for individual investors.

"The buy-and-hold investor has no business being in this kind of fund at all because it's purely speculative," Ferri said. "It's not for any of our clients, that's for sure. We get currency diversification, but we get it for free because we own international equities in our portfolios through index funds. These funds are for traders; they're for speculators. If that's what you want to do -- speculate on the value of the dollar -- and you think you can beat the system, good luck!"

King of Rydex agrees that the currency trade is not for novices.

"It's probably for the more sophisticated individual," King said. "But individuals are getting more and more sophisticated all the time. These funds may be a little bit ahead of their time, but not a lot."

The strengthening and weakening dollar funds provide 200 percent exposure to the U.S. dollar index, which averages the exchange rates between the dollar and a basket of six currencies. The euro is the biggest constituent, at 57 percent, followed by the Japanese yen at about 14 percent, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. If the U.S. dollar index goes up 1 percent, the strengthening dollar fund will go up 2 percent and the weakening dollar fund will go down 2 percent.

For investors who specifically want to trade against the euro, or for those who like to trade several times a day, the euro exchange traded fund may be a better choice than the mutual funds. It tends to move in the same direction as the weakening dollar fund, as it goes up when the euro is rising against the dollar, and drops when the euro falls. Because exchange traded funds are bought and sold like stocks, you can achieve both sides of the trade by shorting it.

So, in theory, how might you use these funds? The first method -- and probably the riskiest -- is to speculate on where the dollar is going. If you have some macro view of the economic climate and think the dollar is poised to strengthen or weaken, you could make a bet with the appropriate fund. If asset levels are any indication, more people are expecting the dollar to weaken before it grows stronger. The strengthening dollar fund holds just $10 million, while the weakening dollar fund is close to $50 million.

Arguments have been made that Americans would benefit from exposure to the weakening dollar fund, King said, since most of their assets are denominated in dollars. But, Ferri points out, most people can get adequate diversification to foreign markets simply by owning international funds.

As international investing has become more popular, King said, investors have started using currency funds for hedging purposes. For example, if you own a fund that is mostly invested in European equities, and the manager doesn't hedge for currency exposure, you could do it yourself if you wanted to. Alternatively, if you own a fund where the manager does hedge out currency exposure, you could add it back in by buying the weakening dollar fund.

For most investors, being exposed to currency risk is not really a bad thing, Ferri said. In fact, it's what you want, for purposes of diversification. Since the majority of foreign stock funds are not hedged, it's not something most investors need to worry about, and routine rebalancing can help manage any risks.

"For no extra cost, in an equity fund, especially a low-cost index fund, you get currency exposure and diversification," Ferri said. "You can get your currency diversification through your equity positions. That's the way a long-term investor would do it. Do not try to be smart about this. People who try to be smart about this will be eating hamburger down the road, while the people who do it our way will be eating steak."