Currency ETF: Meaning, Special Considerations, Examples

What Is a Currency ETF?

A currency ETF is a pooled investment that provides investors with exposure to foreign exchange (forex) or currencies. They allow investors to gain exposure to changes in exchange rates in one or more currency pairs.

Like other exchange-traded funds (ETFs), investors can purchase currency ETFs on exchanges just like shares of corporate stocks. These investments are usually passively managed, and underlying currencies are held in a single country or basket of currencies. Like any investment, currency ETFs come with their own risks and rewards.

Key Takeaways

  • Currency ETFs are exchange-traded funds that track the relative value of a currency or a basket of currencies.
  • These investment vehicles 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.
  • Risks associated with currency ETFs tend to be macroeconomic, including geopolitical risks and interest rate hikes.

How To Trade The Falling Dollar

Understanding Currency ETFs

Exchange-traded funds are similar to stocks because they trade on exchanges, so investors can purchase shares in individual ETFs. But, they are also like mutual funds because they include pooled funds that invest in a portfolio of securities, often tracking a particular asset class, sector, or benchmark index. ETFs cover a variety of industries and investment types, including bonds, commodities, and currencies.

Currency ETFs offer investors a seamless and cheap way to trade currencies during normal trading hours. Through currency ETFs, investors can have access to structured investment exposure in the foreign exchange market—the largest market in the world—through a managed currency portfolio. Some ETFs are guaranteed by foreign currency bank deposits while others are not. Investors look to these funds for their forex market exposure, as well as the ability to mitigate risks and friction costs in the forex market.

In essence, trading currencies is a speculative trade on spot exchange rates. 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 ETF managers can accomplish the goals of their funds 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 ETFs has opened the foreign exchange market more broadly, especially after the Great Recession.

Most of the movement in the currency market comes down to interest rates, global economic conditions, and political stabilities.

Special Considerations

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

Currency ETFs can diversify traditional stock and bond portfolios. They can also be used to take advantage of arbitrage opportunities between currency pairs, or as a hedge against macro-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. 

Some investors are of the belief 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

There's no doubt that trading currencies and currency ETFs can help improve portfolio returns. They can be used as part of a diversified portfolio. For hedging purposes, they are generally best used to counter-manage risks from international investing.

But there are substantial risks in the foreign exchange market. In fact, currency investing has special risks and, therefore, may not be suitable for all investors. Investors should keep in mind that 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. 

Types of Currency ETFs

Currency ETFs are available to track most of the world’s largest global currencies. Ten of the largest currency ETFs by assets under management (AUM), as of January 2021, include the following:

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

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)

Example of Currency ETFs

Consider a U.S. investor with $10,000 in Canadian stocks through the iShares MSCI Canada Index Fund (EWC). With shares priced at $33.16 at the end of June 2008, that investor would have acquired 301.5 shares (excluding brokerage fees and commissions). If they wanted to hedge forex risk, they could sell short shares of the CurrencyShares Canadian Dollar Trust (FXC), which reflects the price of the Canadian dollar in U.S. dollars. When an investor is long the ETF, FXC shares rise when the Canadian dollar strengthens against the U.S. dollar. Shorting creates the opposite result.

If this investor thinks the Canadian dollar will appreciate, they would either refrain from hedging the exchange risk or "double-up" on the Canadian dollar exposure by buying (or "going long") FXC shares. But since we assume the investor wants 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, buying them back at a cheaper price later if the FXC shares fell.

At the end of 2008, the EWC shares fell to $17.43, a 47.4% drop from the purchase price. Part of this decline in the share price could be attributed to the drop in the loonie against the greenback. The investor who had a hedge in place would have offset some of this loss through a gain in the short FXC position. FXC shares dropped 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.

Article Sources
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