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What Can Currency ETFs do for Your Clients?

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While exchanging money for a vacation in a foreign locale had always taken place, some individual investors started looking for ways to make money from exchanging money–without ever leaving their desks. And Wall Street, ever happy to assist, churned out the instruments.

Knowing that there’s a little bit of the swashbuckling Soros in the heart of every investor, Wall Street has gone to great lengths to bring the tools he and other legendary traders use to the masses. Since 2005, when ETF sponsor Rydex began offering shares in the CurrencyShares Euro Trust (FXE), investors have been able to dabble directly in the currency markets, trading the U.S. dollar/Euro exchange rate without ever leaving the comfort of their brokerage account. There are now more than 30 exchange-traded funds listed in the United States that offer exposure to individual currencies, currency baskets, and even currency trading strategies.

For an investor, currency ETFs serve two purposes. As a trading vehicle, they offer the ability to gain exposure to the currency markets without establishing a separate trading account, which would normally trade in volumes of $100,000 and larger and use leverage of up to 250:1. They also offer instant diversification; returns from ETFs holding foreign currencies such as the Chinese yuan or the South African rand tend to have little correlation with the returns achieved by assets denominated in U.S. dollars.

“We’re pretty bearish for the U.S. dollar in the second half of 2009,” said Alec Young, International Equity Strategist with S&P Equity Research. Young said he will look for the dollar to weaken if the global stock markets keep rising, which shows they are willing to take more risk and abandon “safe havens” such as the U.S. dollar. “Generally the dollar is weak when risk aversion recedes. If the recovery disappoints and equity volatility jumps, that tends to help the dollar.”

There’s a remarkable variety of currency ETFs. Some are structured as exchange traded notes, others as trusts or investment companies. Some own cash deposits or money market securities, others achieve their exposure with futures, options, swaps, and forward contracts. (Tax treatment varies accordingly.) There are actively managed funds, passively managed trusts, and index-based funds. Funds have been created to offer short, long, and leveraged exposure to any number of individual currencies against the U.S. dollar. Some funds pay monthly interest, others have no yield at all. Expense ratios typically run from about 0.3% to 1% per year.

Individual currency funds are the most straightforward of the bunch. Rydex, the largest currency ETF sponsor, has nine ETFs (FXA, FXB, FXC, FXE, FXY, FXM, XRU, FXS, and FXF) which simply own foreign bank deposits denominated in currencies such as the Russian ruble and the Mexican peso. Each fund’s share price represents the current exchange rate. If the euro is trading at $1.4251, shares in the Euro Trust will be priced at $142.51. WisdomTree Dreyfus sponsors eight individual currency ETFs (EU, JYF, BNZ, CYB, BZF, ICN, SCR) that are managed to earn local money market interest rates. The firm’s developed market funds own foreign money market securities, while its emerging market funds use forward contracts.

There also are several ETNs tied to individual currencies. Barclay’s iPath has three (ERO, GBB, JYN), while Van Eck’s MarketVectors sponsors ETNs for the Chinese Remnimbi (CNY) and Indian Rupee (INR). Like other ETNs, they avoid the tracking error that ETFs are subject to, but confer credit risk (unlike ETFs), since the notes are obligations of the issuer and do not own assets. Distributions from ETNs are treated as ordinary income.

A small number of funds offer leveraged exposure to individual currencies. ProShares, which markets leveraged and short funds, offers double short and long ETFs for the Euro and yen that buy forward contracts. VanEck has double long (URR) and double short (DRR) Euro ETNs.

Several funds have been launched that hold multiple currencies, usually in emerging markets. Barclays listed three funds, the GEMS Asia 8 ETN (AYT), the Global Emerging Markets Strategy ETN (JEM) and the Asian and Gulf Currency Revaluation ETN (PGD). These funds are linked to hold baskets of currencies, and are designed to offer an income component due to their relatively high yields, but have suffered from low trading volume.

The WisdomTree Dreyfus Emerging Currency Fund (CEW) is another currency basket fund. It owns forward contracts for currencies including the Mexican peso, Brazilian real, Chilean peso, South African rand, Polish zloty, Israeli shekel, Turkish new lira, Chinese yuan, South Korean won, Taiwanese dollar, and Indian rupee. The fund is rebalanced quarterly, but not actively managed.

PowerShares has two basket funds, the U.S. Dollar Bullish Fund (UUP) and U.S. Dollar Bearish (UDN) Fund, which use U.S. dollar index futures to bet for or against the U.S. dollar versus a basket of major currencies: the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc.

Still more complex are two currency funds that are designed to mimic a popular currency trading strategy known as the “carry trade.” The carry trade was especially popular when there was a wide differential between the interest rates required to borrow Japanese yen and to lend U.S. dollars. By borrowing in yen and lending in dollars, traders could capture the spread between the two rates.

Barclays iPath Optimized Carry ETN (ICI) tracks an index designed to reflect the return of the carry trade using a mathematical formula known as the “constrained mean variance optimization technique” to allocate assets for best performance. As of March 30, 2009, the fund was long U.S. dollars, euros, Norwegian kroner, and New Zealand dollars, and short the yen, the pound, the Swiss franc, the Canadian dollar, the Australian dollar, and the Swedish krona. PowerShares DB G10 Currency Harvest fund (DBV) is an ETF that goes long the three currencies of the G10 group with the highest interest rates, and then shorts the three currencies with the lowest interest rates. Both of these funds perform better when the spread between interest rates of various countries is growing.

Overall, currency ETFs have not caught on with investors in the same way equity, fixed-income, or even commodity-based funds have. No currency fund ranks among the top 20 in terms of average daily volume or market capitalization, the key indicators of a fund’s acceptance by investors. Elements, a Wall Street consortium organized by Merrill Lynch, delisted its five currency ETNs in November, 2008, and iPath has stopped listing some of its ETNs on its website.

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]. Send him your ideas for ETF story topics.

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