An ETF Solution

When gaining access to these markets through ETFs, there are two things that must be studied and understood: the return from the underlying assets and the return given by the currency exchange.

There are a few exceptions in the ETF universe of foreign investments. The two emerging market bond ETFs—iShares' EMB and PowerShares' PCY—both only invest in U.S.-dollar-denominated foreign sovereign debt. Also, RevenueShares has an ADR index—RTR—covering the S&P Global 1200 Index.

Below is a graph showing the excess returns given by currency exchanges, represented by excess returns of the MSCI EAFE Index over The MSCI EAFE Local Currency Index shown by the bar graph. The blue line shows the return of the PowerShares DB US Dollar Bullish Fund from Feb. 16, 2007 to Jan. 23, 2009, using monthly returns.

The above graph shows how currency exchanges can give a lot of return or loss over certain periods. The PowerShares BD US Dollar Bullish Fund, UUP, in general sees increased returns as the U.S. dollar excess return over the Local Currency EAFE Index decreases. Note that the PowerShares ETF is compared to index data and not ETF data.

The correlation between the excess return in the EAFE USD Index over EAFE Local Currency Index and PowerShares DB Dollar Bullish Index Fund is -.93 using monthly data from February 2007 to Jan. 23, 2009. This is simply because as the U.S. dollar appreciates against foreign currency, the value of assets held abroad decreases. This is why the ETF—UUP—offsets the effect by appreciating when the dollar appreciates, and as the dollar appreciates, there is a negative effect on the foreign assets held in your portfolio.

Not A Perfect Hedge

The DB Long US Dollar Index is not a replication of the currencies represented in the EAFE Index and therefore cannot and should not be used as a direct currency hedge when investing in the iShares ETF, EFA, which tracks the EAFE Index. However, in general, the DB Long US Dollar Index covers a lot of the same ground as the EAFE Index among developed nations. The US Dollar Bullish Index Fund may be useful in portfolios with extended allocations to foreign markets. The US Dollar Bullish Index Fund can be a useful portfolio tool to offset some of the currency risk an investor is exposed to when investing broadly in foreign markets.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

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