What is Currency ETF?
If you are an investor from the United States, it would be safe to assume that your income as well as expenses are represented in US Dollars, and additionally so are most of your investments. Having all your eggs in basket can make sense, however it is also a good idea to have a backup plan in your investment portfolio just in case the US Dollar declines in value, or even loses its value completely.
As an investor, clearly you understand the importance of getting a good balance of foreign currency exposure in your investment portfolio from your international stocks and bonds. A good way to create that balance is to invest in the actual foreign currencies themselves, and currency ETFs are the easiest solution to that end.
Currency ETFs track any single currency, or a basket of currencies. Investors like yourself can choose from a variety of currency ETF types that are available on the market, and also various approaches for these investments.
Currency ETF Explained
Selections range from ETFs that, in essence, convert US Dollars to foreign bank deposits, then to funds holding active pools of swap contracts. There are also funds to provide you with exposure to baskets of multiple foreign currencies, and even funds providing you with leveraged or inversed exposure to foreign currencies.
It is important to note that some currency investment products that you will find alongside ETFs are actually exchange traded notes (ETNs), which are instruments of debt backed by the issuing bank’s credit, and currency ETFs are individual and separate portfolios with none of its value associated with the sponsor’s solvency. ETNs do have some risk involved, which makes them best left alone as a means of securing currency exposure in the international market.
In its most basic form, the currency ETF is backed by foreign currency bank deposits, and they move up and down in US Dollar value, determined by the value of the underlying currency relative to the US Dollar. For example, a fund with holding assets in EUR bank deposits will rise in value when the value of the EUR appreciates against the US Dollar, and similarly, when the value of the EUR depreciates against the US Dollar, it will also depreciate.
Currency ETFs that attempt to match a foreign currency’s performance are a lot more complex. These types of currency ETFs are created by purchasing currency forward contracts and swap contracts.
These are third-party contracts where the third-party agrees to pay the fund return on the foreign currency in exchange for a fee charged. When it is not possible to purchase foreign currency directly, or when it is unreasonably expensive to purchase foreign currency as a result of foreign laws and regulations, ETFs will commonly use this type of contract, which are actively managed, although this management is commonly limited to the specific contracts they chosen to hold. This type of currency ETF does involve risk, with the possibility of the issuing party defaulting.
Some investors attempt tracking baskets of foreign currencies by dividing their assets and spreading them among the various contracts on different currencies. There may turn out to be an additional level of diversification available by holding multiple currencies. If you are staying focused on one specific currency, this type of currency ETF is likely not to be the best option for you.
The leveraged currency ETF involves trying to double or triple the return value of a currency, and the inverse currency ETF involves inversing the return value, where you would essentially try to have the ETF increase in value, or vice versa. This typically requires you, as the investor, to hold the funds for longer than 24 hours, which can become risky. Leverage and/or inversing the currency ETF funds can create the opportunity to take advantage of certain hedging strategies for an investor who understands the risks involved, and also understands that the loss can be as much as double or triple the initial investment.