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Using ETFs to invest in currencies

Currencies trade 24 hours a day, but the volume in particular currencies is typically concentrated around the local market hours and trading times at the nearest main trading hub.

What is a currency ETF?

Currency ETFs are designed to track the performance of a single currency in the foreign exchange market against the US dollar or a basket of currencies. Today, currency ETFs track most global currencies.

Why are currency linked ETFs important? In the first place they’re necessary for hedging purposes. For example, in 2013, the Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks, gained nearly 59%, whereas Japan ETF EWJ gained 27%. While a respectable return for the ETF, naturally an investor would like the return of the index more. The difference was the value of the yen, which had deteriorated by an equal amount. If an investor would have shorted FXY in an appropriate amount to hedge yen currency risks, they would have realized the full return of the local index. Alternatively, an investor could have invested in a currency hedged equity fund, DXJ. Currency hedged equity funds use forward contracts to hedge out local currency exposure, essentially allowing them to own the underlying equity in USD terms.

Risks associated with currency linked ETFs, especially leveraged and inverse ETFs, includes volatile markets, rapidly fluctuating exchange rates, and the high cost of hedging.

Pros

  • Portfolio diversity: Currency ETFs can add to a portfolio’s currency diversity or can be used as a hedging strategy against the relative value of a particular currency.
  • Make speculative currency trades: can allow investors to speculate on currency valuations by pairing them against other currencies or a basket of currencies.
  • Trades on the market: Unlike foreign currencies, investors can buy currency ETFs through their existing brokerage account and without having to make individual currency or derivative trades.
  • Lower transaction fees: Investors can gain ongoing exposure to the forex market without having to pay the transaction fees involved in buying and selling currencies.
  • Low management fees: Because most aren’t actively managed, the management fees tend to be somewhat low.

Cons

  • Volatility: International currencies can be volatile and investing in foreign currencies exposes investors to the downside risks of other economies and regulations.
  • Basket risk: While currency baskets can help distribute risk, the currencies within can have a huge impact on the return. That requires that investors know enough about each of the currenies to know whether the fund's strategy meets with their objectives.
  • Bankruptcy: Because exchange-traded notes are unsecured debt notes from banks, if the bank connected with the fund goes bankrupt, investors could lose their funds.
  • Taxation: Investors are taxed differently based on how the fund is structured, so there is research required to understand the tax treatment relative of the fund they're purchasing.
From ETF.com

The first currency products came to the market in 2005 in the grantor trust structure, and the ETF structure was not launched into the marketplace until 2008. Some currency ETFs are issued as registered investment companies (RICs) and are registered under the Investment Company Act of 1940. However, grantor trusts, limited partnerships and ETNs are not registered under the 1940 Act.

As registered investment companies, these funds have added flexibility in managing their underlying investments to shape their risk-return profiles. These funds have the protections characteristic of funds structured as registered investment companies, including:

  • Diversified credit risk
  • Limitations on leverage and lending
  • Oversight of a board of directors
  • Assets that are segregated and maintained with a qualified custodian

It's interesting to note that the currency ETFs came to the market under the actively managed fund exemption because they are not tracking indexes even though they are attempting to provide reasonably passive exposure to currency movements and non-US money market rates. The benefits to this active management exemption are mostly in operational efficiency within the structure. Given their flexibility, the funds can alter their investment approach in delivering the desired exposure to shareholders. The FX markets are among the most liquid in the world, but access to locally denominated money market instruments and spot exchange rates differs between various regions. In a few developed markets, the currency ETFs take a direct approach, as they invest directly into locally denominated money market investments.* 

Only a few countries have local money markets with the combination of issuer breadth, development, and accessibility necessary for this direct approach to structuring funds. The currency ETFs providing exposure to less accessible markets use currency forward contracts combined with US cash-type investments to manage and achieve their exposures. This combination produces a risk-return profile that is economically similar to that of a locally denominated money market instrument. In nearly all of the markets for which the ETFs use this approach, trading volume in FX is high enough to support product growth. Because of the liquidity of the underlying portfolios, which combine emerging market currencies with US cash-type products, these ETFs typically feature bid-ask spreads narrower than many credit-specific fixed-income ETFs.

Currently there are 4 main types of currency products available: open-end funds, grantor trusts, commodity pools and exchange-traded notes (ETNs). I mention several times that structure is going to be the new battleground where products compete with similar exposures. Nowhere is this more apparent than in the currency products landscape. Here's a look at some of the characteristics of the currency structures. 

Product Structure Typical Underlying Holdings US Tax Treatment Tax Reporting & Investor Implications
Open-End Fund Currency ETFs (RICs) Treasury bills and currency derivatives (forward-currency and swap), cash equivalents Taxed as Regulated Investment Companies (RICs); generally pass-through of income, gains, and losses to shareholders; in-kind redemptions can reduce recognition of gains at the fund level Shareholders receive annual Forms 1099 reporting dividends, capital gains, and return of capital; in-kind redemptions generally do not trigger gain recognition for the fund, potentially reducing taxable distributions to shareholders
Grantor Trust Currency ETFs Physical currency or cash held in trust Taxed as grantor trusts; income and gains treated as if directly earned by the investor in proportion to their interest Investors report their share of trust income, gains, and losses directly on their tax returns; typically receive annual statements from the trust detailing their share of income and gains
Commodity Pool/Limited Partnership Currency ETFs (Futures-based) Futures contracts on currencies, cash, possibly other derivatives Taxed as partnerships or commodity pools; gains and losses on futures contracts may be subject to Section 1256 mark-to-market rules (60% long-term, 40% short-term capital gain/loss); ordinary treatment may apply to certain foreign currency contracts under Section 988 unless an election is made Investors receive Schedules K-1 reporting their share of income, gains, and losses; Section 1256 contracts are marked to market at year-end; Section 988 may apply to certain contracts unless the partnership makes a qualified fund election for capital treatment
Exchange-Traded Notes (ETNs) Unsecured debt obligations of the issuer, with returns linked to currency indices or baskets Taxed as debt instruments; interest (if any) is ordinary income; gain or loss on sale or redemption is generally capital gain or loss; if denominated in foreign currency, Section 988 applies to currency gain or loss, which is ordinary income or loss Investors receive Forms 1099 reporting interest and capital gains; foreign currency gain or loss on principal and interest payments is ordinary income or loss; basis and gain/loss calculations must account for exchange rate fluctuations


Key Features and Distinctions

  • Open-End Fund Currency ETFs (RICs):

    • Underlying holdings are typically Treasury bills, currency derivatives (forward-currency and swap), and cash equivalents.
    • Taxed as RICs, with income and gains generally passed through to shareholders.
    • In-kind redemptions can minimize recognition of gains at the fund level, reducing taxable distributions.

  • Grantor Trust Currency ETFs:

    • Hold physical currency or cash in trust.
    • Taxed as grantor trusts, so investors are treated as directly owning a share of the trust’s assets and income.
    • Investors report their share of income and gains directly, rather than receiving distributions as with RICs.

  • Commodity Pool/Limited Partnership Currency ETFs (Futures-based):

    • Hold futures contracts on currencies and cash collateral.
    • Taxed as partnerships; gains and losses on Section 1256 contracts are marked to market at year-end and treated as 60% long-term, 40% short-term capital gain or loss.
    • Section 988 applies to certain foreign currency contracts, resulting in ordinary income or loss unless a qualified fund election is made for capital treatment.
    • Investors receive Schedules K-1 and must report their share of partnership income, gains, and losses.

  • Exchange-Traded Notes (ETNs):

    • Unsecured debt obligations of the issuer, with returns linked to currency indices or baskets.
    • Taxed as debt instruments; interest is ordinary income, and gain or loss on sale or redemption is capital gain or loss.
    • Section 988 applies to foreign currency denominated notes, so currency gain or loss is ordinary income or loss.
    • Investors receive Forms 1099 and must account for exchange rate fluctuations in basis and gain/loss calculations.
Tax rates do not include state taxes. High earners may also be subject to an additional 3.8% Net Investment Income Tax (NIIT) that is applied to investment income if your overall modified adjusted gross income (MAGI) is above $200,000 for single filers or head of household, $125,000 for married filing separately, and $250,000 for married filing jointly or a qualifying widow(er) with a dependent child. This table is for educational purposes and general informational purposes only and is not intended to be a substitute for specific tax advice or an interpretation of tax laws. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor and refer to the IRS website at irs.gov to determine the tax consequences of an investment.

Currencies trade 24 hours a day, but the volume in particular currencies is typically concentrated around the local market hours and trading times at the nearest of the three main trading hubs: Asia (Tokyo, Singapore, and Hong Kong), Europe (London), and the Americas (New York). Although futures exist on many currencies, the bulk of FX transactions occur in the over-the-counter interbank markets through spot transactions, forward transactions, and swaps. Tullett Prebon Group Inc., ICAP, and the WM Company provide commonly followed fixing times, but nearly every broker-dealer also provides fixing prices at other designated times. Real-time quotes are generally available via Bloomberg and Reuters data services. For example, Bloomberg produces real-time composite quotes, while Tullett Prebon Group and others have real-time feeds for contracts on currencies available via Reuters and Bloomberg. The less liquid and less accessible the currency, the greater will be the variability in pricing. The general point is the fact that the currency market is an over-the-counter marketplace with varying times of liquidity and accessibility. The ETP issuer has the challenge of defining an intraday indicative value and creating an investment strategy using the currency and money market instruments to best serve the end investor.

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* Currency ETFs are not "money market" funds and do not seek to maintain a constant share price. Article copyright 2011-2025 by David J. Abner, David H. Fry, and Kathy Lien. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange Traded Funds, Create Your Own ETF Hedge Fund: A Do-It-Yourself ETF Strategy for Private Wealth Management, and The Little Book of Currency Trading: How to Make Big Profits in the World of Forex with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Currency ETPs are generally more volatile than broad-based ETFs and can be affected by various factors which may include changes in national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, and global or regional political, regulatory, economic or financial events. ETPs that track a single currency or exchange rate may exhibit even greater volatility. Currency ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the performance of the referenced currency or exchange rate, particularly over longer holding periods.

Concentration risk — The degree of diversification varies significantly from one ETP to another. Certain ETPs target a small universe of securities, such as a specific region or market sector. These ETPs are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus.

Correlation risk — Asset classes that have been historically uncorrelated could become positively correlated. This could produce unexpected results for investors and might lead to a decrease in the overall level of diversification in an investor’s portfolio.

Derivatives risk — Certain ETPs use derivatives to track an underlying index or other benchmark, such as a particular commodity or currency. The prices of derivatives’ contracts are inherently volatile, and even small price movements might result in large losses to the ETP.

Foreign investment risk — Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. All these risks are magnified in emerging markets.

Liquidity risk — The liquidity of an ETP is not only a function of the trading of the ETP itself, but is also directly linked to the liquidity of its underlying securities. Therefore, the degree of liquidity can vary significantly from one ETP to another. An investor’s losses might be exacerbated if no liquid market exists for the ETP’s shares at the time the investor wishes to sell them.

Market risk — ETPs are subject to market volatility and the risks of their underlying securities, which might include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Yield and investment return vary; therefore, an investor’s shares, when redeemed or sold, might be worth more or less than their original cost. Diversification and asset allocation might not protect against market risk.

Secondary-market risk — Secondary-market trading in ETP shares might be halted by a stock exchange because of market conditions, extreme market volatility, or other reasons. Further, investors have no assurance that the ETP will continue to meet the requirements necessary to maintain the listing or trading of its shares or that these requirements will remain unchanged.

Spread risk — An ETP might sometimes trade at a premium or discount to its net asset value (NAV). The premium or discount to NAV can lead to differences between the bid and ask of the ETP, referred to as the spread. The ETP’s premium or discount to NAV and its bid and ask spread might be the result of factors such as supply and demand in the market, the lack of liquidity for the ETP of some of its underlying securities, or the bid and ask spreads of the ETP’s underlying securities. For exchange-traded notes, the discount or premium is relative to their indicative value.

Tracking error risk — The return of an index-based ETP is usually different from that of the index it tracks. The difference can be small or large and might result from the cost of managing and operating the ETP, the timing of the ETP’s trades, the ETP’s holding a smaller basket of securities than the complete set of securities held by the index, or the ETP's holding securities in a different proportion from the index.

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Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

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