What Is a Currency ETF?

Currency ETFs (exchange-traded funds) are financial products built with the goal of providing investment exposure to foreign exchange (forex) currencies. They are usually passively managed with underlying currency holdings in a single country or basket of countries.

Key Takeaways

  • Currency ETFs are exchange-traded funds that track the relative value of a currency or a basket of currencies.
  • Currency ETFs allow ordinary individuals to gain exposure to the forex market through a managed fund without the burdens of placing individual trades.
  • Currency ETFs can be used to speculate on forex markets, diversify a portfolio, or hedge against currency risks.

How To Trade The Falling Dollar

Understanding Currency ETFs

The foreign exchange market for currency trading is the largest market in the world. Currency ETFs provide structured investment exposure to the foreign exchange market through a managed currency portfolio. Investors look to these funds for their foreign exchange market exposure as well as their ability to mitigate risks and friction costs in the 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.

Currencies and government Treasuries are often two closely related investment options that investors may look to for safety. Currencies can typically have a slightly higher relative risk than other safe havens because of their volatility and trading mechanisms. Currency values are usually driven by interest rates, economic conditions, and government politics. Investors may use currencies for safety, speculation, or hedging.

In essence, trading currencies is a speculative trade on spot exchange rates. Currency ETF managers can accomplish the goals of their fund using a few different methods. Currency ETFs may include cash/currency deposits, short-term debt denominated in a currency, and forex derivative 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 more broadly.

Today, currency ETFs are available to track most of the world’s largest global currencies. Ten of the largest currency ETFs by assets under management include the following:

  • Invesco DB US Dollar Index Bullish Fund (UUP)
  • Invesco CurrencyShares® Euro Currency Trust (FXE)
  • Invesco CurrencyShares® Japanese Yen Trust (FXY)
  • Invesco CurrencyShares® British Pound Sterling Trust (FXB)
  • Invesco CurrencyShares® Swiss Franc Trust (FXF)
  • ProShares UltraShort Euro (EUO)
  • Invesco CurrencyShares® Canadian Dollar Trust (FXC)
  • Invesco CurrencyShares® Australian Dollar Trust (FXA)
  • WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU)
  • ProShares UltraShort Yen (YCS)

Exposure to spot exchange rates is perhaps the most fundamental aspect of investing in currencies. Currency funds rise and fall based on their exposures and positioning to either a counter currency or a basket of currencies.

Currency ETFs can add a layer of diversification to traditional stock and bond portfolios. They can potentially be used to arbitrage for or hedge against economic events. 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. 

In the U.S., the U.S. Dollar Index is one of the most closely followed gauges of the U.S. dollar’s performance. Investors can invest in this Index through three popular funds:

  • Invesco DB US Dollar Index Bullish Fund (UUP)
  • Invesco DB US Dollar Index Bearish Fund (UDN)
  • WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU)

Hedging Considerations and Example

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 foreign exchange risk, he or she could 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, when an investor is long the ETF, then when the Canadian dollar strengthens versus the U.S. dollar the FXC shares rise and vice versa. Shorting creates the opposite result.

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 some 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 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 currencies and currency ETFs can help improve portfolio returns but there are substantial risks in the foreign exchange market. Primarily, most currency movements are influenced by ongoing macroeconomic events. A sluggish economic release, volatile political move, or interest rate hike by a central bank can easily impact multiple exchange rates.

Overall, it's important to remember that currency investing has special risks and therefore may not be suitable for all investors. Currencies and currency ETFs can be used as part of a diversified portfolio. Generally, for hedging purposes, they are best used to counter-manage risks from international investing.