Currency ETFs: The Basics

For U.S.-based investors, choosing the right currency ETF for your investment objectives has two steps ...

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For U.S.-based investors, choosing the right currency ETF for your investment objectives has two steps: choosing the exposure you want; and choosing the right structure.

Before diving into the specifics of choosing the right currency ETF, it's important to cover some currency basics, including the common uses of currency funds.

The most common use is simple: speculative betting on currencies and their spot exchange rates. In fact, exposure to spot exchange rates is one of the most fundamental concepts that must be understood before investing in any currency fund.

Currencies are always traded in pairs. For example, you can't just go long the euro in a pure sense; you can only go long the euro against the U.S. dollar or some other counter currency. So in essence, you're always long one currency relative to being short another currency.

The second key concept to understanding currency returns is access to local interest rates. Take the Aussie dollar, for example, which, at the time of this writing, was yielding more than 2 percent. Imagine that you've sold your U.S. dollars to buy Aussie dollars.

As an investor holding those Aussie dollars over a period of time, you deserve interest payments. In fact, playing interest rate differentials is really at the heart of the popular trading strategy called the "carry trade."

So, investors should always remember that the sources of return for currencies are twofold: spot rates + interest.

Many investors also use currency ETFs for hedging purposes. Anyone who has international equities in their portfolio is significantly exposed to currency movements, because as a U.S.-based ETF investor in an unhedged ETF, you are inherently long the underlying currency of the fund's holdings.

Finally, currency ETFs can be used to make long-term macro bets on specific countries or investment themes, like commodities.

Choosing The Right Currency ETF

Step 1: Exposure
Like any investment, the first thing you need to determine is what type of exposure you want. For currencies, that means you first need to determine whether you want to go long or short the dollar against a single currency, or a basket of currencies.

Currently, the majority of funds are "short dollar" strategies, which make you money when the dollar depreciates against its counter-currencies. In fact, of the 39 available applicable ETFs, 29 are short dollar funds, and only eight are "long dollar" strategies (which make you money when the dollar appreciates against its counter currencies).

For those interested in basket strategies, there are a range of products from emerging currencies to the US Dollar Index to those that target carry trade strategies.

For example, let's take a look at two "long dollar" basket strategies: the PowerShares DB US Dollar Index Bullish Fund (UUP | B-39), and the WisdomTree Bloomberg Dollar Bullish Fund (USDU).

The composition of the two funds is vastly different. UUP's index, the US Dollar Index, has nearly 60 percent weighting to the euro. There's also no exposure to the Aussie dollar or any emerging economies.

Meanwhile, the euro gets a significant haircut in USDU, and two major currencies that are excluded entirely from UUP—the Mexican peso and Aussie dollar—are included. Plus, USDU provides exposure to emerging currencies like the Korean won, Chinese yuan and Brazilian real.

So, depending on the composition of the basket, returns can vary greatly, so choose your basket carefully based on your outlook.

Step 2: Structure

Once you determine your targeted exposure, currency investors have an additional step to tackle: understanding how the fund is structured. In the currency space, products stretch across four different structures: grantor trusts; open-ended funds; commodities pools; and exchange-traded notes.

It's imperative to understand their differences, because each of the structures comes with its own unique strategies, risks and tax implications, which can impact your overall total returns.

For example, CurrencyShares products are structured as grantor trusts. They give investors exposure to spot exchange rates of the underlying currency by holding the foreign currency in bank accounts.

Meanwhile, WisdomTree and PIMCO offer currency ETFs structured as open-ended funds. These funds hold the bulk of their assets in T-bills, while gaining exposure to the reference currencies mostly through forward-currency contracts.

Similar to many commodity funds, some currency funds are structured as commodity pools and hold futures contracts to gain exposure to the underlying currencies.

Finally, currency ETNs are unsubordinated, unsecured debt notes issued by banks that promise to provide the return of a specific index or exchange rate. This means they carry credit risk: If the bank issuing the note goes bankrupt or defaults, investors can lose their entire investment.

Next: How Are Currency ETFs Taxed?

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