Which Euro ETF Is Right For You?

by on February 11, 2010 | ETFs Mentioned:

One of the major stories of 2010 has been turmoil in the euro zone, as crumbling public finances in Greece have stoked fears of a “contagion effect” sweeping throughout the region. The prolonged economic downturn has left Greece with a massive budget deficit, and with $28 billion in debt due in April and May, fears of a default have soared in recent weeks. The government’s plans to rein in the deficit–including pay cuts, bonus freezes, and some hefty tax hikes–have met stiff resistance, as evidenced by the recent strikes from civil servants.

Reflecting the extent to which global financial markets are now interconnected, Greece’s financial mess has weighed on stocks around the world, primarily on worries that a default there would be the first domino to fall. Several other European economies, including the much larger Spain and Portugal, have been tagged as potential threats as well, as skyrocketing unemployment has sapped government tax revenues and left massive deficits.

The currency of the euro zone has also been hammered by the recent developments, sliding against almost all of its major rivals. Beyond the short-term implications, the recent crisis has raised concerns over the long-term sustainability of the euro system. Most economies in the euro zone are showing signs of improvement, an indication that the time to begin raising interest rates may be nearing. But others remain mired in prolonged economic slumps, forcing the ECB to walk a very fine line. The crisis has exposed a major weakness of the common currency system: member states are free to spend as they like, but their largess can impact all 16 euro zone nations.

Euro Ready To Rally?

Now wealthy European nations appear to have adopted a plan to swallow a bitter but necessary pill, rescuing Greece from its dire situation before its debt drags the currency down further. With a group led by Germany and France seemingly ready to act as a backstop to guarantee Greek debt, some investors have begun to wonder if the market has punished the euro too severely, and if the currency may be poised to claw back some ground in coming weeks.

Euro ETF Options

For contrarian investors looking to gain exposure to the euro through exchange-traded products, there are three primary options available: the iPath EUR/USD Exchange Rate ETN (ERO), CurrencyShares Euro Trust (FXE), and WisdomTree Dreyfus Euro Fund (EU). While these three products offer similar exposure, they are far from identical, and each maintains a unique risk and return profile.

ERO is structured as an exchange-traded note (ETN), meaning that it is a senior, unsecured debt instrument issued by Barclays. As with all ETNs, an investment in ERO is subject to credit risk: if the issuing bank defaults on its obligations, there is no underlying pool of assets to which investors have a claim. Although the likelihood of default is relatively low, it is a risk that investors should consider.

Both FXE and EU invest their underlying assets in eur0-denominated securities. This means that interest earned on these investments, in addition to changes in the EUR/USD exchange rate, will contribute to total return (although money market and bank deposit rates are currently near zero). Neither FXE nor EU are ETNs, but there are some structural differences between these products as well. FXE is a currency grantor trust, while EU is a true 1940 Act exchange-traded fund. The distinction is a subtle one, but has the potential to result in material differences in return.

Currency grantor trusts generally hold foreign bank deposits, meaning that there is again concentrated credit risk with the depository bank (although, again, such risk is relatively minimal). EU, on the other hand, is a true ETF, meaning that it is required to spread risk across multiple counterparties. At present, this fund has holdings in about 12 different securities, including Belgian, French, and German Treasuries and time deposits at RBS and UBS (see the complete list here). Particularly in the current tumultuous environment, the benefits of diversification in holdings can be significant.

The second difference between FXE and EU relates to taxes. Upon the liquidation of shares in a currency grantor trust (i.e., FXE), proceeds are generally taxed at an ordinary income rate. But proceeds from the sale of an actively-managed currency ETF (i.e., EU) are generally taxed at the capital gains rate according to the holding period. For investments held for less than a year, the difference may be minimal. But for longer-term investments, the ETF structure can result in lower taxes. There are also some potential advantages to the taxation of gains on currency forward contracts under the actively-managed ETF structure: assuming the fund makes appropriate tax elections, these gains can be taxed at 60% long-term / 40% short-term rates.

The tax issues around these investments are complex, and the exact treatments can vary depending on individual circumstances. But in most cases, the ETF structure will offer superior tax efficiency. The differences highlighted above may not seem material, but in a game of basis points, every little advantage can translate into a bigger bottom line.

Disclosure: No positions at time of writing.