What Is a Currency ETF?
Currency ETFs (exchange-traded funds) are designed to track the performance of a single currency in the foreign exchange market against the US dollar or a basket of currencies.
This is accomplished by multiple methods like cash deposits, short-term debt denominated in a currency, and future or swap contracts. In the past, these markets were only accessible to experienced traders but the rise of exchange-traded funds over the past decade has opened the foreign exchange market to all types of investors.
- Currency ETFs are exchange traded funds that track the relative value of a currency vs. the U.S. dollar or a basket of currencies.
- Currency ETFs allow ordinary individuals to gain exposure to FX markets in an inexpensive way in their normal brokerage account.
- Currency ETFs can be used to speculate on Forex markets, to diversify a portfolio, or to hedge against currency risk.
How To Trade The Falling Dollar
Understanding Currency ETFs
Currency ETFs are used by investors looking for exposure to the foreign exchange market and would prefer to transact outside the futures or forex market. The rising popularity of ETFs offer investors a seamless and cheap method to trade currencies throughout normal trading hours. Most of the movement in the currency market comes down to interest rates, global economic conditions, and political stabilities. Sometimes a natural disaster in an emerging country can rock the currency market, but that occurs independently of trading behavior. Today, currency ETFs track most global currencies including the US dollar, Canadian dollar, Euro, British pound, and Japanese yen.
In essence, trading currency ETFs is a speculative trade on spot exchange rates. Exposure to spot exchange rates is perhaps the most fundamental aspect of investing in currency funds. This means investors are betting on one of two outcomes: the core currency performs well or the counter currency tumbles. The investor always takes a long position on a currency relative to being short another one. For example, the CurrencyShares Euro Trust (FXE) rises when the Euro performs well or the US Dollar tumbles. Besides currency appreciation, investors receive interest rate payments for holding currency over time.
Currency ETFs add a layer of diversification to traditional stock and bond portfolios by hedging against economic events that might undermine normal trading. Different products offer varying risk-reward opportunities and provide exposure to different currencies. Basket investments in multiple currencies may offer more stability than a currency-specific product, but with less upside potential. Many of the same guidelines of modern finance like diversification and risk management apply to trading the currency market.
Hedging Using Currency ETFs
Consider a U.S. investor who invested $10,000 in Canadian stocks through the iShares MSCI Canada Index Fund (EWC). This ETF seeks to provide investment results that correspond to the price and yield performance of the Canadian equity market, as measured by the MSCI Canada index. The ETF shares were priced at $33.16 at the end of June 2008, so an investor with $10,000 to invest would have acquired 301.5 shares (excluding brokerage fees and commissions).
If this investor wanted to hedge exchange risk, he or she would also have sold short shares of the CurrencyShares Canadian Dollar Trust (FXC). This ETF reflects the price in U.S. dollars of the Canadian dollar. In other words, if the Canadian dollar strengthens versus the U.S. dollar, the FXC shares rise, and if the Canadian dollar weakens, the FXC shares fall.
Recall that if this investor had the view that the Canadian dollar would appreciate, he or she would either refrain from hedging the exchange risk or "double-up" on the Canadian dollar exposure by buying (or "going long") FXC shares. However, since our scenario assumed that the investor wished to hedge exchange risk, the appropriate course of action would have been to "short sell" the FXC units.
In this example, with the Canadian dollar trading close to parity with the U.S. dollar at the time, assume that the FXC units were sold short at $100. Therefore, to hedge the $10,000 position in the EWC units, the investor would short sell 100 FXC shares, with a view to buying them back at a cheaper price later if the FXC shares fell.
At the end of 2008, the EWC shares had fallen to $17.43, a decline of 47.4% from the purchase price. Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U.S. dollar over this period. The investor who had a hedge in place would have offset part of this loss through a gain in the short FXC position. The FXC shares had fallen to about $82 by the end of 2008, so the gain on the short position would have amounted to $1,800.
The unhedged investor would have had a loss of $4,743 on the initial $10,000 investment in the EWC shares. The hedged investor, on the other hand, would have had an overall loss of $2,943 on the portfolio.
Some investors may believe that it is not worthwhile to invest a dollar in a currency ETF to hedge each dollar of overseas investment. However, since currency ETFs are margin-eligible, this hurdle can be overcome by using margin accounts (brokerage accounts in which the brokerage lends the client part of the funds for investment) for both the overseas investment and currency ETF.
Risks of Currency ETFs
Trading currency ETFs can help improve portfolio returns but there are substantial risks in the foreign exchange market. For one thing, most currency movements are influenced by ongoing macroeconomic events. A sluggish economic release, volatile political move or interest rate hike can impact multiple exchange rates. Overlooking the current macroeconomic environment can be costly for investors thinking about trading in the foreign exchange market.
It's important to remember that currency investing should represent a small portion of your overall investment strategy and is meant to soften the blow of currency volatility.