Home >  Wealth > Products Back To Articles Listing
Jun. 10, 2009
| | Pdf |Print

Products: A Simple Way to Gain Currency Exposure

Font Plus Minus

Are Currency ETFs Any Good For Your Portfolio?

Currency ETFs these days are quite the rage. It is a relatively new product category, first started in 2006. Recently various currency ETF providers have further expanded their product range. So, are these products useful for affluent private investors?

What are currency ETFs?

The first point to note is that there are two types of those exchange traded currency vehicles, one is called ETF Exchange Traded Fund) and the other ETN (Exchange Traded Note). The subtle but important difference is that ETNs carry a credit risk (if the issuer goes bankrupt the investor will most likely loose all or part of the invested money), whereas ETFs carry a tracking risk. ETFs have virtually no credit risk but they may not follow their underlying index very closely. In the following we will refer to all of these products as ETFs, since this term is more commonly used.

Say you invest in a simple Euro/USD ETF (one example is from Barclays, another one from Dreyfus. These ETFs gain when the Euro appreciates against the USD and loses proportionally when the Euro falls. On top of this, the ETFs usually pay the interbank rate in interest (in this case for the Euro). But be careful, fund fees have to be paid, which are usually around 0.5% of the invested money. Some funds leverage http://seekingalpha.com/symbol/urr the currency changes; other funds reflect specific currency strategies http://seekingalpha.com/symbol/dbv like carry trades. In summary, a currency ETF is a straightforward, pre-packaged currency product.

Advantages of currency ETFs: Simplicity and flexibility

The main advantage is to give investors the ability to gain simple exposure to foreign currencies. For instance, if your home currency is USD, a Euro/USD ETF gives you exposure to any gains or losses the Euro makes against the USD. So, if an investor wants to profit from the falling USD, he can simply buy those ETF shares on an exchange. He can also sell them any time, just as easily as any other ETF.

More exotic currencies like the Mexican Peso, the Chinese Yuan or the Swedish crown are also on offer. The advantage is that there is no need to actually hold the respective foreign currency in cash, which can be expensive and does not generate any interest. There is also no need to buy currency futures or indulge in currency forward trades. Both may involve the opening of separate accounts and can often only be done with large amounts.

Another advantage is that ETFs enable simple currency hedging. You may be a Chinese investor and hold some USD investments but are bearish on the USD vs. the Euro. You can hedge your investments for instance with a leveraged double long Euro ETF. For every percentage point the USD loses vs. the Euro this ETF would gain 2%. It could, of course, also work in the other direction. Another strategy to hedge the US holdings would be to shorten an USD/Euro ETF.

The disadvantages: Relatively expensive and capital gets tied up

As simple and straightforward these products seem, there are also a number of clear disadvantages:

  • No matter whether ETF or not, currency trading is difficult. Many analysts think that exchange rates are even less predictable than stock prices.

  • Currency ETFs carry fees: 0.5% per annum can add up over time. If you hold foreign cash or are involved in currency forward sale, usually no fees or lower fees apply.

  • In most cases you have to invest the full amount to gain currency exposure. So if you desire to have 100 USD exposure to the Euro you have to invest 100 USD. Exceptions are leveraged funds.

  • More complex currency strategies can quickly become quite risky. People who did carry strategies with the Icelandic crown have had very bad experiences when the crown went down in a very short timeframe. If such risky trades are wrapped in a strategy ETF, the fund can generate substantial losses but investors would hardly be aware of this risk.

Conclusion: Currency ETFs are simple but they come with substantial costs and some risks

And the conclusion? On the surface, currency ETFs are simple and straightforward products. But beware! They entail substantial risks and costs. If you really want foreign currency exposure, consider other alternatives:

  • For USD-based investors: Investing in a straightforward Euro money market fund may save you quite some money since they often have only fees of 0.15% per year (rather than around 0.4 to 0.5% on a currency ETF). The simple money market fund is also protected against bankruptcy of the issuer in most cases.

  • Buying or selling a currency forward contract instead of an ETF could be more cost effective (i.e. you agree to buy or sell currency for a fixed rate in the future. Depending on the change in the exchange rate, you either gain or lose).

However, for more exotic currencies the ETF may actually be the better option because there may just not be any simple alternatives other than the pre-packaged product for the private investor.

Related Articles and Research

My Private Banking



Products: A Simple Way to Gain Currency Exposure

Are Currency ETFs Any Good For Your Portfolio?

  Jun. 10, 2009

Currency ETFs these days are quite the rage. It is a relatively new product category, first started in 2006. Recently various currency ETF providers have further expanded their product range. So, are these products useful for affluent private investors?

What are currency ETFs?

The first point to note is that there are two types of those exchange traded currency vehicles, one is called ETF Exchange Traded Fund) and the other ETN (Exchange Traded Note). The subtle but important difference is that ETNs carry a credit risk (if the issuer goes bankrupt the investor will most likely loose all or part of the invested money), whereas ETFs carry a tracking risk. ETFs have virtually no credit risk but they may not follow their underlying index very closely. In the following we will refer to all of these products as ETFs, since this term is more commonly used.

Say you invest in a simple Euro/USD ETF (one example is from Barclays, another one from Dreyfus. These ETFs gain when the Euro appreciates against the USD and loses proportionally when the Euro falls. On top of this, the ETFs usually pay the interbank rate in interest (in this case for the Euro). But be careful, fund fees have to be paid, which are usually around 0.5% of the invested money. Some funds leverage http://seekingalpha.com/symbol/urr the currency changes; other funds reflect specific currency strategies http://seekingalpha.com/symbol/dbv like carry trades. In summary, a currency ETF is a straightforward, pre-packaged currency product.

Advantages of currency ETFs: Simplicity and flexibility

The main advantage is to give investors the ability to gain simple exposure to foreign currencies. For instance, if your home currency is USD, a Euro/USD ETF gives you exposure to any gains or losses the Euro makes against the USD. So, if an investor wants to profit from the falling USD, he can simply buy those ETF shares on an exchange. He can also sell them any time, just as easily as any other ETF.

More exotic currencies like the Mexican Peso, the Chinese Yuan or the Swedish crown are also on offer. The advantage is that there is no need to actually hold the respective foreign currency in cash, which can be expensive and does not generate any interest. There is also no need to buy currency futures or indulge in currency forward trades. Both may involve the opening of separate accounts and can often only be done with large amounts.

Another advantage is that ETFs enable simple currency hedging. You may be a Chinese investor and hold some USD investments but are bearish on the USD vs. the Euro. You can hedge your investments for instance with a leveraged double long Euro ETF. For every percentage point the USD loses vs. the Euro this ETF would gain 2%. It could, of course, also work in the other direction. Another strategy to hedge the US holdings would be to shorten an USD/Euro ETF.

The disadvantages: Relatively expensive and capital gets tied up

As simple and straightforward these products seem, there are also a number of clear disadvantages:

  • No matter whether ETF or not, currency trading is difficult. Many analysts think that exchange rates are even less predictable than stock prices.

  • Currency ETFs carry fees: 0.5% per annum can add up over time. If you hold foreign cash or are involved in currency forward sale, usually no fees or lower fees apply.

  • In most cases you have to invest the full amount to gain currency exposure. So if you desire to have 100 USD exposure to the Euro you have to invest 100 USD. Exceptions are leveraged funds.

  • More complex currency strategies can quickly become quite risky. People who did carry strategies with the Icelandic crown have had very bad experiences when the crown went down in a very short timeframe. If such risky trades are wrapped in a strategy ETF, the fund can generate substantial losses but investors would hardly be aware of this risk.

Conclusion: Currency ETFs are simple but they come with substantial costs and some risks

And the conclusion? On the surface, currency ETFs are simple and straightforward products. But beware! They entail substantial risks and costs. If you really want foreign currency exposure, consider other alternatives:

  • For USD-based investors: Investing in a straightforward Euro money market fund may save you quite some money since they often have only fees of 0.15% per year (rather than around 0.4 to 0.5% on a currency ETF). The simple money market fund is also protected against bankruptcy of the issuer in most cases.

  • Buying or selling a currency forward contract instead of an ETF could be more cost effective (i.e. you agree to buy or sell currency for a fixed rate in the future. Depending on the change in the exchange rate, you either gain or lose).

However, for more exotic currencies the ETF may actually be the better option because there may just not be any simple alternatives other than the pre-packaged product for the private investor.