Sonya Morris, CPA, at Morningstar gave a review of 5 increasingly popular ETFs that began trading here in 2007. Ms. Morris provided analysis of the:

(1) CurrencyShares Japanese Yen Trust (FXY)
(2) Vanguard FTSE All-World Ex-Us ETF (VEU)
(3) UltraShort Financial ProShares (SKF)
(4) Vanguard Total Bond Market ETF (BND)
(5) Powershares DB Agriculture (DBA)

In truth, I fully expected to disagree with the folks at Morningstar. In fact, over the last decade, I’ve bashed their star rating system and slammed their unwillingness to embrace the ETF revolution. However, after reading the review, I discovered that Ms. Morris and I were on the exact same page on 4 out 5 issues.

For example, the Powershares DB Agriculture Fund (DBA) slices and dices the commodity pie such that you only get exposure to things like wheat, oil, corn and sugar (i.e., agricultural products). Perhaps that is the way you’d like it, but it’s not going to make a lot of sense for a more diversified portfolio.

What about oil and natural gas? Guess you’ll need an oil proxy. What about industrial metals like aluminum and copper? Now you need another ETF.

Ms. Morris and I both agree that the best way to get diversified exposure to the commodity universe is through the iPath Dow Jones AIG Commodity Index ETN (DJP). This benchmark covers the entire gamut, while capping a commodity segment (energy, metal, agriculture) to a maximum of 33% of the index movement. (I’ve written extensively about the benefits of iPath Dow Jones AIG Commodity Index in previous posts as well.)

Other issues that I concur with Ms. Morris include the unsuitability in Q4 2007 of the UltraShort Financial ProShares (SKF). That free ride ended when the Fed changed its course and decided to bail out banks, brokers and insurers with dramatic interest rate cuts.

A more targeted way to profit from the turnaround in financials can be had with the KBW Bank Index (KBE). Not only is it undervalued today, but Citigroup, Bank of America and Wells Fargo are going to fare even better than brokerages, lenders and other financial services sub-sectors. (See why Warren Buffett has been eying financial firms.)

There is one area where I strongly disagree with the Morningstar CPA, and that is, the importance of currency ETFs. Ms. Morris writes, "Short-term currency bets can be difficult to pull off successfully. Not only do you have to handicap a myriad of complex economic factors, but you’ve also got to get the timing right."

For one thing, who is suggesting that one needs to make a short-term bet on a particular currency? If one believes, as I have for quite some time, that the U.S. dollar is/has been in a long-term downtrend against other world currencies, why shouldn’t one choose an exchange-traded currency fund? (I am not choosing the CurrencyShares Japanese Yen Trust either… but this is not the point to be made.)

Ms. Morris believes that the best way to hedge against the falling dollar is through the use of diversified international equity exposure.  Not only does that miss the opportunity to achieve diversification across asset classes like international fixed income (See  Foreign Fixed Income (BWX): True Diversification Has Finally Arrived), but it also ignores the risk reduction achieved when employing world currencies rather than ultra-volatile foreign equities.

In other words, one is unlikely to choose 100% equities — domestic or international. If one has 70% in domestic and international equities, shouldn’t one have 30% in domestic and international income? That’s where currencies come in! That’s where currencies provide diversification and sleep-at-night risk reduction. 

Don’t misunderstand… foreign equity exposure accounts for 30%-35% of my investments. But I have found exceptional profitability at the low end of the risk scale with CurrencyShares Euro Trust (FXE) and CurrencyShares Canadian Dollar Trust (FXC).

Perhaps the easiest way to prove this point is with a picture. Ms. Morris contends that the best way to hedge against a falling dollar is through diversified international equity exposure. That can be had with the iShares Europe 350 (IEV). I maintain that you should have some world currencies for fixed income as well as international equities.

The chart suggests that your reward is greatest from the international equity arena. Yet it also suggests that, slow-n-steady currency appreciation can still occur, without the threat of a global credit crisis or the next bear market. Clearly, it makes sense to diversify across different international asset classes.

Disclosure Statement:  As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

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