ETFs have opened up the doors to previously hard-to-reach reach corners of the market, including foreign equities, commodities and alternative asset classes. Currency ETFs in particular have seen growing interest among investors and traders alike as they greatly simplify the challenges that are otherwise associated with entering the forex market [see How To Take Profits And Cut Losses When Trading ETFs].
How Currency ETFs Work
Currency ETFs attempt to replicate the movements of a currency on the foreign exchange market (forex) against the U.S. dollar (USD), or a basket of currencies. This is done by using cash deposits, such as holding euros or Swiss cash for example, or through the use of futures and swaps contracts to achieve a desired exposure [Download 101 ETF Lessons Every Financial Advisor Should Learn].
If you believe the euro, other active global currency or a basket of currencies will rise or fall relative to the USD, currency ETFs provide a way to capitalize on that. When you purchase a currency ETF you’re betting the price of the currency will rise – short-sell it and you’re betting the price will drop. It is a quick way to capitalize on forex moves without opening a separate forex trading account, which has its own rules, regulations, fees/spreads and brokers.
What’s the Difference?
There are two main types of currency ETF products: those that reflect a specific currency versus the USD, and those that reflect a basket of currencies against the USD.
A currency-specific ETF, such as the CurrencyShares Euro Trust (FXE) tracks the euro/USD forex pair. Figure 1 shows how well the ETF has matched the movements of the euro/USD (pink) over an eight-month period.
A currency basket ETF on the other hand, such as the Dreyfus Emerging Currency Fund (CEW), invests in multiple currencies relative to the USD. In this case, the ETF will increase in value if these currencies on average perform better than the USD [see King Dollar ETFdb Portfolio].
Figure 2 is list of currency-specific exchange-traded-products (ETPs).
Figure 2. Currency-Specific Funds
Figure 3 highlights currency basket ETPs.
|UUP||United States Dollar (Bullish) vs. Basket||0.50%||Buys only USD futures contracts relative to other major currencies (basket).|
|CEW||Emerging Currency||0.55%||Invests in emerging currency markets|
|DBV||G10 Currency Harvest||0.81%||Goes long futures in highest G10 interest rate currencies, and short futures in the lowest interest rate currencies|
|CCX||Commodity Currency||0.55%||Invests in commodity-related currencies|
|ICI||Currency Carry||0.65%||Invests in high yielding G10 currencies by borrowing in low-yielding G10 currency markets–carry trade.|
|AYT||Asia 8||0.89%||Invests in the 8 currency markets of Asia|
|PGD||Asian & Gulf Currency Revaluation||0.89%||Invests in 5 currencies: Hong Kong, Singapore, Saudi Arabia, United Arab Emirates and China|
The different products offer varying risk and opportunity levels, and they provide a wide range of exposure to different currencies. Baskets invest in multiple currencies, and therefore should theoretically have more price stability than a currency-specific product, although that doesn’t mean currency basket products don’t experience volatility – at times these baskets of currencies can be very volatile if affected by a regional event or news. One type of product is not better than the other, but each investor must thoroughly critique what they are seeking, and the risks they can accept, before deciding which product is the right fit.
The currency markets allow global commerce to run smoothly, facilitating the transfer of products and services from one place to another. According to the 2010 Bank for International Settlement data (the next report is expected in 2013), global foreign exchange volume is estimated at $3.98 trillion per day, or about $83 trillion per month. Much of this is speculation, as global world product (GWP)—the global equivalent of GDP—is estimated at $69 -79 trillion per year. Much of the volume that occurs above the actual trade of goods and services is speculation, and can cause significant volatility, very long-term trends and rapid changes in direction [see How To Invest Overseas Without Currency Risk].
The forex market is very sensitive to news releases that may change people’s view of a currency going forward. Interest rate and Federal Reserve announcements as well as economic data releases typically have the largest impact in this regard. Below we highlight some of the major data/news releases that affect the forex market. In the moments before and after these announcements hit the market, expect increased volatility and wider bid-ask spreads in the currency ETFs you are trading.
Keep in mind that the news event affecting one currency or country may affect other currencies as well – even those that are seemingly unrelated. Therefore, news events such as those discussed in the next section are noteworthy when released by any major country, and the names of releases may vary by country. Locate an economic calendar that shows all news and data reports scheduled for release in each country to stay on top of news that may affect your currency ETF. Many of these calendars rate the news events, from high to low, according to the expected market impact.
Major News Events And Impacts
Federal Reserve or Central Bank announcements
News releases from banking committees, financial bodies such as treasuries or reserve banks relating to interest rates or economic outlooks can shift perception and are widely watched and traded.
Consumer or Product Price Index (CPI, PPI)
These indexes provide inflation data and therefore provide clues as to interest rate direction, affecting short- and long-term direction in currencies.
Gross Domestic Product (GDP)
This is an indicator of how a country is doing economically and therefore provides valuable fundamental data to currency traders.
New and Existing Home Sales, Retail Sales and Unemployment data
All indicators that provide data on the financial condition of consumers within a country’s economy tend to affect how a country is perceived by global and domestic traders.
Talks by people in power, such as heads of state, Federal Reserve(s) or Treasury departments can sway markets based on their bullish or bearish comments.
Manufacturing and Construction Data
Looks at growth or contraction in the manufacturing sector; an indicator of economic health.
Trade Balance, Balance of Payments, Current Account and Debt Levels
Numbers that reflect economic health, growth or contraction, which have long-term effects on the demand and supply of a currency.
Unscheduled news events play a significant role in inducing fear or greed in investors, causing them to dump one currency, rushing into another. This includes everything from earthquakes to parliamentary elections.
Commodity and Other Market Prices
Commodities and other financial markets are affected by currency rates, and currency rates are affected by changes in other markets. Monitor correlations between asset classes to determine what a drastic change in the commodity or stock complex may do to currencies, or vice versa.
Currency ETF Trading Tips You Need
ETFs listed on the American markets will be active during the U.S. session, but actual currency trades around the clock, with the most activity occurring during the U.S. and London market hours. Since currency ETFs are thinly traded outside of U.S. market hours, be wary of trading the open and close (U.S hours) as sharp movements can occur to bring the ETF back in line with its NAV (net asset value), or large orders may cause a significant deviation from NAV [see 7 Rules ETF Day Traders Must Know].
Currency ETFs are exposed to frequent opening gaps in price, and ETF traders won’t be able to capture all of the intra-day moves available on the 24-hour forex market. As with any trading vehicle, use stop-loss orders to control downside risk; incorporate limit orders into your trading in attempt to get favorable pricing during peak and off-peak trading times; and take profits using a disciplined technique as currencies can be volatile and change direction quickly.
The Bottom Line
Currency ETFs provide a convenient way for investors to access the forex market through their current stockbroker. Currency ETFs can be divided into two broad categories—currency-specific and basket—each providing unique advantages and disadvantages. Currencies can be volatile due to high speculation and sensitivity to news; as such, closely monitor global news, both scheduled and unscheduled, to stay on top of short- and long-term events that can shape future trends. Always monitor downside risk, and take profits when profit potential looks to be waning.
Disclosure: No positions at time of writing.