Currency ETFs: Definition, Types & List of Funds

What Is a Currency ETF?

A currency ETF is a fund that’s traded on a stock exchange that tracks the relative value of a particular currency or a basket of currencies. ETFs can be passively or actively managed but currency ETFs are generally passively managed.

Currency ETFs allow investors to hedge their investment portfolio against the risks of currency volatility or devaluation, especially if they’re too heavily invested in securities denominated in one currency. Currency ETFs can also be used to speculate on potential movements in the forex market without having to directly purchase and sell currencies or currency futures. A benefit of these funds is that they’re traded on the stock exchange and can be bought and sold through an investor’s existing brokerage account.

Tip: Investors should understand that currency funds don’t all just purchase currencies—they use long and short futures or forwards contracts in order to track the value of a particular currency against one or more other currencies. Thus, positions are commonly paired when traded. For example, if the fund wants to hold a bullish position on the British Pound relative to the Euro, it might hold long futures positions on the Pound and short futures positions on the Euro.

How Is a Currency ETF Different From Other ETFs?

Most ETFs function as index funds that buy securities or other investments in order to track existing indexes on stock or bond markets. Currency ETFs are different in that they’re focused exclusively on the relationship between one currency and another, or between one currency and a basket of currencies. Currency ETFs thus offer investors exposure to the relative values between different currencies, something that could be part of a strategy to diversity or hedge the currency risk in a portfolio that is overexposed to investments denominated in certain currencies.

They also offer a chance for investors to speculate on fluctuations in currencies that may result from geopolitical or economic policy actions by sovereign nations.

Currency ETFs, however, do come with risks. For example, currencies can fluctuate in value for reasons not necessarily apparent, or can fluctuate more or less than anticipated relative to others.

Tip: The majority of currency ETFs are ‘short dollar’ funds. That means that investors make money when the currency they purchased the ETF in, often the US dollar, depreciates relative to the currency or basket of currencies they are holding in the ETF. However, there are also some ‘long dollar’ strategies where investors make money when the dollar appreciates instead.

Types Of Currency ETFs

It’s important for investors to know the difference between the types of currency ETFs because the structure determines things as important as the fund’s investment strategy, risks, upside potential, and tax considerations.

• Grantor’s Trusts: hold the currencies in question in bank accounts
• Open-ended Trusts: hold the majority of their funds in treasury bills but are exposed to foreign currencies they’re focused on via forward-currency contracts
• Commodity Pools: hold futures contracts for currencies
• Exchange-Traded Notes: hold debt notes from banks whose interest is indexed to a specific currency or exchange rate

Pros & Cons Of Currency ETFs

Pros

• Portfolio diversity: Currency ETFs can add to a portfolio’s currency diversity or can be used as a hedging strategy against the relative value of a particular currency.
• Make speculative currency trades: can allow investors to speculate on currency valuations by pairing them against other currencies or a basket of currencies
• Trades on the market: Unlike foreign currencies, investors can buy currency ETFs through their existing brokerage account and without having to make individual currency or derivative trades.
• Lower transaction fees: Investors can gain ongoing exposure to the forex market without having to pay the transaction fees involved in buying and selling currencies.
• Low management fees: Because most aren’t actively managed, the management fees tend to be somewhat low.

Cons

• Many trades are paired: That involves an added level of complexity and increases the risk that an investor can be wrong if a relationship between two currencies does not pan out as expected.
• Volatility: International currencies can be volatile and investing in foreign currencies exposes investors to the downside risks of other economies and regulations.
• Basket risk: While currency baskets can help distribute risk, the currencies within can have a huge impact on the return. That requires that investors know enough about each of the currencies to know whether the fund’s strategy meets with their objectives.
• Bankruptcy: Because exchange-traded notes are unsecured debt notes from banks, if the bank connected with the fund goes bankrupt, investors could lose their funds.
• Taxation: Investors are taxed differently based on how the fund is structured, so there is research required to understand the tax treatment relative of the fund they’re purchasing.

Sample List of Different Types of Currency ETFs

1. Basket currency ETFs: WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU): Holds a basket of currencies including the Australian dollar and emerging-market currencies. Long the US Dollar, meaning investors make money when the US dollar increases in value relative to the currencies held in the fund’s basket.
2. Single currency ETFs: Invesco CurrencyShares Canadian Dollar Trust (FXC): Holds a single currency: the Canadian Dollar. Short on the US Dollar, meaning investors make money when the US dollar decreases in value relative to the Canadian dollar.
3. Long-dollar ETFs: Invesco DB US Dollar Index Bullish Fund (UUP): Investors make money when the US dollar does well against the basket of currencies this fund indexes it against.
4. Short-dollar ETFs: Invesco CurrencyShares Swiss Franc Trust (FXF): Investors make money when the Franc increases in value against the US dollar.
5. Grantor’s Trusts: Invesco CurrencyShares Euro Trust (FXE): Holds Euros in bank accounts. Investors make money when the euro increases in value against the dollar.
6. Commodity Pools: Invesco DB US Dollar Index Bearish Fund (UDN): Holds a basket of currencies in a commodity pool, which means that it holds futures contracts for currencies. Short the US Dollar—does well when the US dollar weakens relative to the basket of currencies.

Warning: This is not a recommendation for any particular fund. Also, size is not necessarily an indication of performance. Before investing in a currency ETF, investors need to make sure that the fund’s structure and strategy meet with their investment objectives.

Bottom Line

A currency ETF can be a useful investment option for those looking to diversify their portfolio, decrease their overexposure to certain currencies, or take advantage of fluctuations in the forex market without having to invest directly in currencies or derivatives themselves.