Currency ETFs and What You Need to Know

Currency ETFs (exchange-traded funds) allow investors to engage in the zero-sum game of betting on the rise or fall of the U.S. dollar, the European Union’s euro, the Swiss franc or other currencies.

In this article, you will learn:

• What are currency ETFs and how do they work
• Why Invest in a Currency ETF?
• Types and examples of currency ETFs
• Benefits and risks of currency ETFs
• Bottom Line: Should you invest in currency ETFs?

This article provides important details regarding currency ETFs that investors can use to optimize their decisions. Keep in mind that in any zero-sum game, the end result is that investors who profit do so at the expense of others who take the opposite positions and lose money.

What are Currency Exchange-Traded Funds (ETFs) & How Do They Work?

Currency ETFs are funds that hold baskets of currencies and allow investors to profit from movements in the price of currencies in the foreign exchange (forex) market. Those funds are traded like any ordinary ETF but, contrary to standard forex trading in which investors have to trade based on a fixed contract, currency ETFs are flexible so that investors are free to choose their exposure to a given basket of foreign currencies.

When trading currency ETFs, it’s important to take into consideration spot exchange rates, which are the costs involved in exchanging one currency for another. Currency funds rise and fall in value in response to the movement of a counter-currency. This is another aspect of currency ETFs because it almost always involves shorting a currency and trading in pairs of currencies. In essence, an investor trading currency almost always shorts a currency to bet on another currency going up.

Why Invest in a Currency ETF?

There are two principal reasons why an investor would choose to invest in a currency ETF:

1. Currency Speculation

In this case, the investor believes that a particular foreign currency is over or undervalued and wants to speculate on the price of that foreign currency going up or down. For example, the investor may believe that the United Kingdom’s pound is undervalued. In which case, the investor could buy shares in FXB – the Invesco British Pound Sterling ETF.

2. Hedging

Hedge away the foreign currency risk involved with another investment in a person’s portfolio.

This investment rationale is a little more complex. Let’s take an example: consider an investor with $25,000 in iShares Europe ETF (IEV). By purchasing shares in IEV,  the buyer is investing in companies that primarily do business in the European Union and whose shares are traded in euros. The result is that the investor could lose money even if the underlying stocks went up if the euro fell compared to the U.S. dollar. To remove or hedge away this currency risk (and therefore have a pure investment in the underlying companies), the person could short a euro currency ETF. IE: One of the main reasons why investors buy or short sell currency ETFs is to hedge against foreign currency risk when they’re already holding positions in international ETFs. Therefore, the investor described above can short-sell shares of Invesco CurrencyShares Euro Trust (FXE), which shows the price of euros converted to U.S. dollars. When the investor is holding a short position in FXE, it means that the value of the fund rises when the U.S. dollar appreciates in value against euros. Such a move would offset the currency risk involved with owning the iShares Europe ETF

Types & Examples of Currency ETFs

There are a limited number of currency ETFs tracking the world’s most popular currencies.

Below is a short list of currency ETFs:

• UUP – Invesco DB US Dollar Index Bullish Fund
• FXE – Invesco CurrencyShares Euro Trust
• FXF – Invesco CurrencyShares Swiss Franc Trust
• FXY – Invesco CurrencyShares Japanese Yen Trust
• FXC – Invesco CurrencyShares Canadian Dollar Trust
• FXB – Invesco CurrencyShares British Pound Sterling Trust
• USDU – WisdomTree Bloomberg US Dollar Bullish Fund
• FXA – Invesco CurrencyShares Australian Dollar Trust

Benefits & Risks of Currency ETFs

Currency ETFs can help diversify an investor’s portfolio with a different type of investment (currency speculation) as well as help manage risks or hedge against risks involved with international investing.

However, like many securities, there are risks to face.

Many of these risks are macroeconomic events that can cause drastic changes in foreign currency prices. For example, the actions of foreign governments can have a huge impact on the currency in that country if they enact certain policies. For example, Brexit is a term that describes the United Kingdom’s withdrawal from the European Union. Despite concerns about the fate of the British pound due to Brexit, the currency has held steady thus far with the euro. Furthermore, political turmoil and confusion within a country could also negatively impact a nation’s currency. Since currency exchange usually involves central banks within a country, these banks also can impact currency movements.

Bottom Line: Should You Invest in Currency ETFs?

Currency ETFs are usually passively managed funds and can be useful tools for hedging against foreign exchange rate risks when investors already hold international securities. Such currency ETFs also are helpful in diversifying a portfolio by investing in an asset category that is not correlated with the stock market.

However, investors must understand the volatility involved in trading currencies and currency ETFs because the valuations can be affected by the political and economic events within the respective countries.

Thus, staying up to date with the economies of different countries is important if a person wants to invest in currency ETFs because political and economic events can affect exchange rates and thereby their valuations.