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 Index in Japan 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.
- 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.
- 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.
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.
|Tax Treatment on Gains
|Currency ETF (open-end fund)
|Investments in money market securities; some use forward currency contracts
|Long term: up to 20%; Short Term: up to 37%
|Currency ETF (Grantor Trust)
|Holds foreign currency in bank account
|Ordinary income regardless of holding period
|Currency ETF (Limited Partnership)
|Holds futures contracts
|Up to 30.6% maximum regardless of holding period (Note: This is a blended rate that is 60% maximum long-term rate and 40% maximum short-term rate)
|No underlying holdings
|Ordinary income regardless of holding period
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.