The last time we looked at currencies in this column, markets were still bottoming. But what a difference some five months can make.

In that Alternative Investor piece, we were focusing on the idea of using "commodity currencies" as a method of participating in a commodity recovery with the possibility of reduced risk. (See earlier column here.)

Since then, the CurrencyShares Australian Dollar Trust (NYSEArca: FXA) has gone from $63.96 a share to open Monday at $83.82 a share. That’s a pretty nice little run-up. But consider that the CurrencyShares Canadian Dollar Trust (NYSEArca: FXC) is up nearly 20% and the CurrencyShares Mexican Peso Trust (NYSEArca: FXM) is up some 17%.

And toss into the mix the WisdomTree Dreyfus New Zealand Dollar (NYSEArca: BNZ) has returned nearly 30% since March 3.

Meanwhile, the PowerShares DB Commodity Index Tracking ETF (NYSEArca: DBC) is up around 24%.

However, it is important to take a look at volatility to obtain a clearer picture. DBC suffered a drawdown of nearly 15% from its peak on June 11, while FXA only dropped around 5% on that commodity sell-off. In addition, many of the currency ETFs pay a small amount of monthly income.

Know What You’re Buying

All of this may sound like sweet music to your ears. But take extreme caution before loading up a portfolio with currency ETFs. So let’s review how these sorts of investments actually work and get a better feel for how they can work together in a portfolio with other asset classes.

First of all, it’s important to note that each currency ETF trades based on the relationship between that currency and the U.S. dollar. For example, if the Australian dollar is improving, that means the U.S. dollar is weakening versus AUD. If an investor is long FXA, they are in turn short the USD versus the AUD.

This is a bit different than trading the U.S. Dollar index, which is the relationship of the greenback versus a basket of currencies heavily weighted toward the euro, but including several others. An investor buying an individual country currency ETF is expecting that currency to appreciate versus the U.S. dollar, while an investor buying the PowerShares DB U.S. Dollar Index Bullish (NYSEArca: UUP) is expecting the U.S. dollar to be generally strong. 

Another important element of currency ETFs to keep in mind is that these investments must be viewed as any other asset class—and separate from others such as stocks or bonds. This means that a currency investor is not exempt from having a strategy that includes risk management. 

As such, investors should be aware of the many moving parts to currency pricing—including interest rates, economic positions and country stability, to name a few. Because of this, a currency investor must be every bit as diligent with their risk management as a stock investor.

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