Exchange traded funds (ETFs) provide a flexible way to manage the currency exposure of your portfolio.
For U.S. investors, having some non-dollar exposure in your portfolio could help you diversify further in case the dollar falls in value.
We explore different types of currency ETFs, including those backed by bank deposits in a foreign currency; ETFs with forwards and swaps; currency basket ETFs; and leveraged and inverse ETFs.
If you're a U.S. investor, your income and expenses are probably in U.S. dollars. Many of your investments, including U.S. stocks and bonds (and mutual funds and ETFs that hold them) are also in U.S. dollars. Having your investments in the same currency as your expenses can make sense, but having some non-dollar exposure in your portfolio could help you diversify further in case the dollar falls in value.
In addition, if you're not getting enough foreign currency exposure (or you're getting too much) from your international stocks and bonds, you might think about investing in foreign currencies themselves. One of the easiest ways to do this is via currency ETFs.
What is a currency ETF?
Currency ETFs track a single currency or basket of currencies. There are several types of currency ETFs on the market, with various investment approaches. These range from ETFs that essentially convert dollars to foreign bank deposits to funds that hold actively-managed pools of swap contracts. There are even funds that provide exposure to baskets of multiple currencies, or funds that provide leveraged or inverse exposure to currencies.
ETFs vs. ETNs
First, it's worth noting that some currency products that may be lumped alongside ETFs are actually exchange-traded notes (ETNs). ETNs are debt instruments backed by the credit of the bank that issues them, while ETFs are separate portfolios of securities whose value is not tied to the solvency of the sponsor of the fund. ETNs have credit risk, and may not be the best means to obtain currency exposure.
ETFs backed by bank deposits
The simplest currency ETFs are backed by bank deposits in a foreign currency. They simply move up and down in dollar value based on the value of the underlying currency relative to the dollar. A fund that holds its assets in euro-denominated bank deposits, for instance, should go up in value when the euro appreciates against the dollar and fall in value when the euro depreciates against the dollar.
ETFs with forwards and swaps
Somewhat more complicated are ETFs that try to match the performance of a foreign currency by purchasing currency forward contracts and/or swap contracts. These are contracts where a third party (another bank, in many cases) agrees to pay the fund the return on the foreign currency in exchange for a fee. ETFs tend to use these contracts when directly purchasing the foreign currency is impossible or overly expensive due to foreign laws and regulations. Many of these ETFs are actively managed, though their active management tends to be limited to the specific contracts they choose to hold. These ETFs do carry some counterparty risk; that is, the risk that the institution issuing the forward or swap contracts may default.
Currency basket ETFs
A few funds attempt to track baskets of non-dollar currencies by spreading their assets among a variety of contracts on different currencies. These funds may provide an additional level of diversification by holding more than one currency, but probably would not be a good fit for an investor with a view on a specific currency.
Leveraged and inverse currency ETFs
The final category is leveraged and inverse currency ETFs. These ETFs have their own risks, especially for investors who plan to hold the funds for longer than a day. The ability to use leverage (attempting to earn double or triple the return of a currency) or inverse exposure (attempting to have the ETF rise in value when the currency drops in value, and vice versa) can open certain currency hedging strategies (such as protecting the value of foreign stock investments when the foreign currency drops in value) to investors who understand the risks—most importantly, that losses can also double or triple.