Currency ETFs: Macroeconomic Trader's Game

ETFZone

Most currency ETFs are for Dollar bears. They invest in foreign sovereign debt. This cranks out modest interest, but their primary feature is exposure to foreign currency.Right now Dollar weakness is a bit of a challenge. Although the US has its problems including US monetary laxity, weak economic fundamentals and low interest rates, economists and currency strategists voice greater concern for other economies underpinning major currencies such as the Euro and Yen. The Euro could disintegrate if Germany refuses to bail out Mediterranean economies of the Common Market. Unless Japan can get a handle on its crushing debt load, eventually the Yen should devalue.Currency investing is essentially a zero sum game, unlike equity investments. Dollar exposure only prospers from Euro weakness and vice versa in that exchange pair. Recent years have been stellar for the Euro, but in early 2010 investors would have been far better off toughing it out in the US equity market than fleeing to the Euro (SPY below tracks the S&P 500; the others track the Euro):

View gallery

.
These Euro funds track well. Both WisdomTree Dreyfus Euro ETF (NYSEArca:EU - News) at .35% annual expenses and CurrencyShares Euro Trust (NYSEArca:FXE - News) at .40% fees hover around the Euro spot price consistently. iPath EUR/USD Exchange Rate ETN (NYSEArca:ERO - News), with .40% fees, had a previous hiccup but is doing a fine job now.Other European currency ETFs include:
  • CurrencyShares British Pount Sterling Trust (NYSEArca:FXB - News); expense ratio .40%
  • CurrencyShares Swedish Krona Trust (NYSEArca:FXS - News); expense ratio .40%
  • CurrencyShares Swiss Franc Trust (NYSEArca:FXF - News); expense ratio .40%
  • iPath GBP/USD Exchange Rate ETN (NYSEArca:GBB - News), .40%
The Japanese Yen is another major currency well-served by ETFs, including:
  • CurrencyShares Japanese Yen Trust (NYSEArca:FXY - News), .40% annual fees
  • iPath JPY/USD Exchange Rate ETN (NYSEArca:JYN - News), .40% annual fees
  • WisdomTree Dreyfus Japanese Yen ETF (JYF), .35% fees
Currency investing is by nature a trader's game. Since major currencies tend to cycle back and forth in value, there is little point to long-term passive strategies. Currencies of economically troubled countries are more likely to devalue steadily for decades, but they tend to be quite risky and are vulnerable to geopolitical shocks. In either case, ETF investors need to watch their funds and cycle in and out at appropriate moments.For the investor who wants to leave the active management to the fund, an interesting strategy is adopted by iPath Optimized Currency Carry ETN (NYSEArca:ICI - News) with .65% fees. ICI systematically engages in the carry trade whereby low-yielding currencies are borrowed and exchanged for high-yielding ones. For instance, in 2008 ICI sold the Dollar to invest in the Euro and the Yen. In 2009 it invested most heavily in the Norwegian Krone based on borrowings from the Swedish Krona.PowerShares DB G10 Currency Harvest Fund (AMEX:DBV - News) is a somewhat similar ETF with fees of 0.75%. It buys futures for three G10 currencies earning high interest and sells futures for three G10 currencies earning low interest. An active fund with a regional focus is Barclays Asian and Gulf Currency Revaluation ETN (NYSEArca:PGD - News), with annual fees of 0.89%.These are designed to prosper in varied economic times, and short-term returns suggest they are doing just that in a modest way:

View gallery

.
These funds do not exactly offer a free lunch because all this activity creates transaction fees and management overhead, and there is risk that invested currencies (long) will fall while currencies borrowed (sold short) rise. The decision on what to buy and sell is not done subjectively, so it is not a matter of whether great traders are at work. At least in theory a standard optimization formula dictates the moves in hopes of obtaining the best theoretical risk/reward ratio. The creation of that formula may be subjective and guided by great minds, but its deployment is not.Other useful country or regional ETFs include:
  • CurrencyShares Australian Dollar Trust (NYSEArca:FXA - News), .04% fees
  • CurrencyShares Canadian Dollar Trust (NYSEArca:FXC - News), .04% fees
  • CurrencyShares Euro Trust (NYSEArca:FXE - News), .04% fees
  • CurrencyShares Mexican Peso Trust (NYSEArca:FXM - News), .04% fees
  • CurrencyShares Russian Ruble Trust ETF (NYSEArca:XRU - News), .04% fees
The most interesting currencies in terms of speculation are emerging market ones such as the Chinese Yuan/Renminbi, but they are often tightly controlled by their governments and are less suitable for an ETF.Betting for or against the Dollar is perhaps the simplest way for Dollar-denominated portfolios to hedge or speculate on currency risk. ETFs for this purpose include:
  • PowerShares DB US Dollar Index Bullish Fund (AMEX:UUP - News), .50%
  • PowerShares DB US Dollar Index Bearish Fund (AMEX:UDN - News), .50%
Both are straightforward trading tools which buy and sell futures contracts on the Dollar and other major currencies. UUP aims to prosper if the Dollar strengthens relative to a basket of other major currencies which is the majority view at present. UDN is the mirror trading tool of UUP. It buys into a basket of futures of the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc, hoping they will rise relative to the Dollar. With the Dollar somewhat firmer, a case could be made for another slide, but the majority opinion is that it will continue to gain.There are a few percentage points of drag in each (buying both funds delivers slightly negative return), as the following graph shows :

View gallery

.
Unfortunately, most currency ETFs generate high ordinary income taxes. The IRS considers most of them debt, so interest proceeds are ordinary income. Worse still, gain on the sale of a fund is taxed at ordinary income rates, not the much lower capital gains rate. An exception can occur with multiple-currency ETFs, however investors should consult with a tax accountant to confirm this for any specific fund.Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.

Rates

View Comments (0)