Exchange-traded funds and exchange-traded notes have opened the doors to the average investor by making currency investing cost-effective and as easy as stock trading.

The usefulness of currency ETFs, however, may be more than as just a different sort of long-term asset class or as tactical tools to build a rotating portfolio.

Consider that research is increasingly pointing to relatively attractive long-term growth prospects in emerging and non-U.S. developed markets.

As investors slowly shift more assets to these foreign markets, the need to lessen the effect of currency fluctuations may become more necessary within diversified portfolios.

Sizing Up The Field

A pair of broad-based currency ETFs from PowerShares may offer a way to lessen the effect of currency fluctuations, the DB US Dollar Index Bullish (NYSE: UUP) and the DB US Dollar Bearish Index (NYSE: UDN).

The two indexes track the same index, the Deutsche Bank US Dollar Index. The Bullish UUP holds a long position of the index, while the Bearish UDN holds short positions in the underlying futures contracts that make up the index.

As the dollar rises against many other developed nations' currencies, in general the Bullish Dollar Fund will rise. When investors are holding a broad range of foreign stocks through broad-based ETFs like the iShares MSCI EAFE Index (NYSE: EFA), their portfolio values are negatively affected by these increases in the value of the dollar against the foreign countries they are invested in.

UUP rises when the value of a broad-based fund such as EFA is negatively impacted by currency exchange fluctuations. As such, used correctly, an investor may be able to offset the negative effect of the currency exchange with UUP.

Any foreign asset's return gives the investor the return of the currency exchange plus the price return of the asset. The graph below shows the currency exchange return from holding the foreign assets within the MSCI EAFE Index as a U.S. investor using annual returns.

The International Monetary Fund (IMF), in its World Economic Outlook Update issued Nov. 6, 2008, projects the output for 2009 in developed markets to be -0.3% relative to 2.2% growth in output for the world. The regions expecting the highest growth in output among developed economies are the most newly industrialized Asian countries.

They project that the output for emerging and frontier markets will increase 5.1%. Putting this in perspective, the U.S. and Europe are projected to decrease output by .7% and .5%, respectively, in 2009, compared to 2008; this is to say that outside the U.S., there are significant opportunities for growth. One thing that cannot be overlooked, as U.S. investors invest abroad, is the effect of currency exchange.

In the past, favorable currency exchanges have driven huge excess returns for the U.S. investor. Matt Hougan writes about this affect in his blog. The return on any foreign asset is equal to the price return plus any fluctuations from currency exchanges. The exchange of the U.S. dollar to buy foreign assets through ETFs at times can be significant, as can be seen from the spread between the MSCI EAFE Index denominated in U.S. dollars compared to the local currency.

Through UUP, investors can realize the return from a negative currency exchange, and in general, minimize the effects of increased volatility for the currency exchanges in their ETFs holding foreign assets. As was shown above, returns as reported can differ widely from the actual experience of an investor. Of course, in the past, the U.S. investor has been very happy with the depreciating dollar against the foreign currencies in the MSCI EAFE Index. However, currency movements are hard to predict, and all investors should analyze if offsetting the currency risk in their portfolios is important or needed.

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 .