There are many ways to gain exposure to the currency markets.  Over the past decade, foreign currency ETFs have surged in popularity, allowing those who have equity brokerage accounts to gain access to this market.

An ETF is an exchange traded fund that generally holds assets.  For example, a forex ETF is likely to hold over the counter currency pairs, currency futures as well as sovereign bonds that are denominated in a specific currency. Initially, liquidity was an issue, but during the past 5-years, ETF’s have experienced increasing volume as more participants enter the market.

Exchange traded funds are investment products that can replicate the movement of an index or a specific asset class such as currency pairs.  ETF’s allow investors to enter and exit their positions during normal trading hours. 

ETF’s differ from mutual funds in that they provide intra-day liquidity and the ability to allow investors to exit during the trading day, as opposed to an end of day price.  ETFs are considered attractive investments because of their low costs, and stock-like features.

If you are someone that has a stock account and you want to start trading the currency market within that equity account, you can trade currency ETFs. This might initially be easier than finding and opening a separate account with a futures or forex broker to trade currency futures or the spot FX market.

How a Currency Exchange Traded Fund Works

ETF management is a lucrative business.  A fund management company will purchase an asset such as a currency pair and hold it in a fund.  They will then sell shares of the fund to the public. You can purchase shares of an ETF just like you would buy a stock.

A currency ETF is expected to mimic the performance of either a specific currency pair or, a basket of currencies. There are risks associated with both currency ETF’s as well as currency basket ETFs. Since a currency basket invests in many currencies, you have some diversification benefits, which can reduce your individual exposure to a single currency.

But, there will be times when even a currency basket ETF is effected by regional news. For example, a basket of the major currency pairs against the dollar, might experience increased volatility if Australia decides to raise its interest rates.

Additionally, if you are looking to specifically trade a spot exchange rate, an ETF will not provide that specific exposure.  Since ETFs generally hold a combination of assets, the correlation to a spot currency pair will be less than 100%.

The most liquid currency basket ETF is the PowerShares DB US Dollar ETF Index Bullish Fund. The ETF also experiences the largest trading volume of the currency ETFs listed in the United States. Since the ETF is a basket of currencies versus the U.S. dollar it attempts to replicate the performance of the Euro, the British Pound, the Japanese Yen, the Swiss Franc, and the Swedish Krona. The ETF tracks the price of the Deutsche Bank Long US Dollar Futures index. The manager’s only hold futures in this trust, that are designed to track the movement of the currencies versus the U.S. dollar. 

One of the issues with this basket is that most of the allocation, more than 50%, is the Euro versus the US dollar. So, while the index is a basket, it is lopsided with most of the direction generated from changes in the EUR/USD currency pair.  While this basket might provide exposure to the Swiss Franc for example, if you want direct exposure you are better served purchasing an ETF that only holds Swiss Francs.

Currency ETF Trading

Currency ETFs that are listed on U.S. exchanges are active when the U.S. market is open. There is a pre-market, before 9:30 AM ET, and post market, following 4:00 PM ET, but these periods are generally not very liquid.  Since the currency markets are global and trade around the clock, currency ETFs are exposed to share price swings and gaps, as the over the counter market changes while the ETFs are closed for trading.

This can be an issue for an ETF trader that wants to use specific price stops. For example, is you are short the FXE ETF on April 23, and you place a stop loss at 104, you would not get filled until the open on the next day at 105.30 (red arrow).  If you place a stop loss limit trade, at 104.50, with a limit of 104.75, you would not get filled, as your limit is less than the low of the day.

If you are trading the currency markets and require good liquidity during periods when Asia or Europe is open, then currency ETFs can be restrictive.  For example, if you want to trade out of your position following a Bank of Japan monetary policy announcement, during the Asian time zone, the liquidity provided by currency ETFs can be limited.

One of the benefits of trading a currency ETF is that it trades like a stock, so, you can see volume and open interest numbers that can help you with some trading strategies.  For example, if the price of an ETF is breaking out of a triangle chart formation on strong volume the breakout is considered to be confirmed. If it is breaking out on weak volume, the move might be a fakeout and could potentially be quickly reversed.

Currency ETF versus Currency ETNs

A currency ETF is a fund that attempts to generate returns of assets that it holds in a trust.  For example, a GBP/USD British pound ETF will purchase futures on the GBP/USD currency pair.

A currency ETN (exchange traded note), is a bond that does not pay interest, where the prices of the note change with the changes in an underlying exchange rate.  An ETN is generally unsecured debt, which means that is you purchase one of these instruments you are also taking credit risk.  While unlikely, a circumstance could arise where the underwriter defaults, leaving you with unsecured collateral.

It is a good idea to perform some due diligence prior to investing in an ETN. You should evaluate the credit rating of the underwriter, to determine if they are a viable credit counterparty.  Most ETN underwriters are banks with stellar credit. In theory if the underwriter of an ETN were to receive a credit downgrade the value of your ETN could likely decline as well.

One of the benefits of holding an ETN instead of an ETF is that since the manager of the ETN does not buy and sell assets that are held by the manager, the ETN does not trigger gains that would require a tax event. The ETN will only trigger a tax event when the bond matures or the fund is sold, which would be considered a long-term capital gain, which has a tax rate that is lower than the short-term capital gains or the income gains generated by an ETF.

Tracking Dispersion 

Another benefit of trading ETNs is that there are no tracking errors. Since the product is a bond, it is not tracking the assets that it holds so there are no tracking errors. ETFs on the other hand, experience a range of tracking errors, because of the varying expenses each ETF charges.  Since ETNs are not buying and selling assets, the expenses are minimized allowing them to have virtually no tracking error.  An exchange traded note just pays an investor when the bond matures based on the price of an index or asset.

Which is Better – Currency ETF or ETN?

While the ETF is easier to understand that an ETN, the ETN has a more favorable tax treatment for long term investors, as well as minimal expenses and very little tracking error. That being said, the ETF is easy to understand, and you know exactly the performance you are trying to replicate.  There is also a much larger collection of ETFs than ETNs.

Top 10 Most Liquid U.S. Currency ETFs

Power Shares, Pro-shares, Guggenheim and Wisdom Tree are the largest and most active U.S. listed currency ETF players in the market. 

The most liquid U.S. currency ETF is PowerShares US dollar Index Bullish fund which is a basket of currencies that are traded against the U.S. dollar.  This fund has assets under management that exceed 558 million USD and has average daily volume of more than 1 million shares per day. Below is a list of the top ten most liquid currency ETFs as of June 2017:

The expenses that are charged to investors are reported as an expense ratio. The expense ratio is the fee that is charged by the fund manager to shareholders of the ETF.  The ratio, which is reflected in percentage terms, describe the percent of assets that will be deducted from the fund each year to pay for fund expenses. 

The expenses include, management fees, administration fees, and operating fees. It can also include interest expenses as well as dividends on borrowed securities.  For example, if a fund generated a short sale on a security, and the stock paid a dividend, the fund would count the dividend that it needed to pay, as an expense. Payments to auditors, the custodian or transfer agency would also fall into the expense ratio calculation.

Fees that are not included in the expense ratio include brokerage fees, sales charges or transaction fees.

Expense fees are fixed, which means that they need to be covered for the fund to run regardless of the size of the fund.  If the fund is small, the expense ratio might need to be large to cover the fixed expenses. 

An expense ratio is usually listed by the fund and can also be found on the fund’s annual report. Any changes to the expense ratio will also be described in the annual report.

Leveraged Currency ETFs

A leverage ETF is a fund that borrows capital in an effort to generate returns that are a multiple of the returns expected from a non-leveraged ETF. 

Most leveraged ETFs listed in the United States attempt to provide 2 or 3 times the performance of a non-leveraged ETF.  For example, if a non-leveraged currency ETF had actual returns of 10%, you would expect a 2x leveraged ETF to provide returns of 20%. 

A leveraged fund generates its leverage by borrowing capital similar to the way you would use a margin account to increase the returns on an over the counter currency trade. For example, a fund that has a net asset value of $50 they could borrow an additional $50, investing the borrowed capital in the currency pairs that are held in the fund to attain a performance that is double the performance of the target.

Short Currency ETFs

For most forex traders the concept of shorting or selling is very familiar.  If you sell a currency pair such as the EUR/USD you believe that the exchange rate will move lower over time, and so you could sell the currency pair now at a higher price and buy it back later at a lower price.

When you short a stock or ETF, you must have a margin account that will allow you to borrow capital to sell the stock or ETF, and then buy it back when it moves lower.  To accommodate investors that do not have margin accounts, many ETF managers have introduced short currency ETFs.  A short currency ETF, moves higher as the underlying target moves lower.

This allows investors to speculate that a currency index will move lower without having to borrow the ETF and sell it short.  The manager embeds this process in the ETF for investors, making it easy to speculate that a currency will decline in value.  In addition, some managers provide leveraged short ETFs, that will increase the leverage by 2x or 3x. For example, the EUO, UltraShort Euro ETF is the most liquid short currency ETF. The goal of the managers is to provide returns that are 2x the return of the Proshares short Euro ETF.

Options on Currency ETFs

Another nice feature of currency ETFs is that there is a liquid options market that trades like stock options.  Many of the more liquid currency ETFs have weekly, monthly and quarterly settlement options that are listed on the Chicago Board of Options Exchange. 

FX Options allow you to limit your risk as well as take non-directional positions on a currency pair. Recall, a call option is the right to purchase a currency ETF at a certain price on or before a specific date. A put option provides the buyer the right to sell a currency ETF at a specific price on or before a certain date.

Summary

Currency ETFs and ETNs are stock like products that allow investors to speculate on the direction of a currency pair or basket.  Most baskets are made up of a few currency pairs, but many have most of the allocation in one or two currency pairs.  One of the issues traders face when trading currency ETFs is that they are not liquid around the clock, and therefore traders will experience a gap in price, when a currency pair moves while the ETF market is closed. For shorter term traders, this limits your ability to efficiently trade using stop loss orders.

Currency ETNs allow you to track a currency, but instead of investing in a trust that tracks the daily movements of assets that it owns, you own a bond, that has a maturity date, that tracks the price of an asset when it matures.  There are tax benefits that are favorable for ETNs, but you are taking credit risk and must perform due diligence into the ETN underwriter to make sure they have a strong credit rating.

For investors who are looking to diversify their portfolio and add an alternative asset class such as currencies, foreign exchange ETFs are great instruments to trade.  These products are well regulated, and you can trade them inside your stock equity account, bypassing the need to find a separate currency broker.