ETFs: An Advanced FAQ

A leveraged ETF uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available for most indexes, such as the Nasdaq-100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

A leveraged ETF does not amplify the annual returns of an index; instead it follows the daily changes. For example, in the case of a leveraged fund with a 2:1 ratio, each dollar of investor capital used is matched with an additional dollar of invested debt. On a day in which the underlying index returns 1%, the fund will theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full effects of leverage.

The 2:1 ratio works in the opposite direction as well. If the index drops 1%, the fund’s loss would then be 2%.

The goal of a leveraged ETF is for future appreciation of the investments made with the borrowed capital to exceed the cost of the capital itself.

The typical holdings of a leveraged index fund would include a large amount of cash invested in short-term securities, and a smaller, but highly volatile, portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.

A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Most derivatives are characterized by high leverage. There are also inverse-leveraged ETFs that sell the same derivatives short. These funds profit when the index declines and take losses when the index rises.

What are currency ETFs?

Currency ETFs allow investors to invest in foreign currencies in the same manner as with stocks or any other ETF. Currency ETFs replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked, or using futures contracts on the underlying currency.

Either way, these methods should provide a highly correlated return to the actual movements of the currency over time. These funds typically have low management fees, as there is little management involved in the funds, but investors should be advised to examine the fees before purchasing.

There are several choices of currency ETFs in the marketplace, including ETFs that track individual currencies. For example, the Swiss franc is tracked by the CurrencyShares Swiss Franc Trust (NYSE:FXF). If an investor believes that the Swiss franc is set to rise against the U.S. dollar, he or she may want to purchase this ETF, while a short sell on the ETF can be placed if an investor believes that the Swiss currency is set to fall.

ETFs that track a basket of different currencies are also available. For example, the PowerShares DB U.S. Dollar Bullish (NYSE:UUP) and Bearish (NYSE:UDN) funds track the U.S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. If an investor believes that the U.S. dollar is going to fall broadly, it may be advisableto purchase the PowerShares DB U.S. Dollar Bearish ETF.

There are even more active currency strategies used in certain currency ETFs.

In general, much like other ETFs, when a currency ETF is sold, if the foreign currency has appreciated against the dollar, the sale will produce a profit. On the other hand, if the ETF’s currency or underlying index has declined relative to the dollar, a loss is generated. There is, however, a difference in how these profits are taxed. Most currency ETFs are in the form of grantor trusts. This means that the profit from the trust creates an ordinary income tax liability for the ETF shareholder based on the rules that apply to grantor trusts.

As a result, currency ETFs are not eligible for the typically favorable long-term capital gains rates, even if the ETF is held for a period of several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods.

What is a “Double Gold” ETF? How is its yield taxed?

A Double Gold ETF is an exchange-traded fund that tracks the value of gold and responds to movements in the same manner as an otherwise similar double leveraged ETF. A double gold ETF is one in which the spot value of gold or a basket of gold companies acts as the underlying asset for the fund. The ETF attempts to deliver price movements that are twice the value of the movements of the underlying gold. It is important to note that even though there is a potential for recognizing significant profits with this strategy, the risk of loss is also significant because the price could fall dramatically.

Double gold ETFs are by no means a unique fund product. There are numerous leveraged ETFs that aim to deliver movements equal to two or more times the movements of their underlying assets. Some examples include leveraged ETFs on natural gas and crude oil. These ETFs can also aim to mimic an inverse movement relative to the underlying assets; such ETFs are known as inverse or bear ETFs.

It is also important to remember that trades or investments in gold are treated as “collectibles” for tax purposes. The same applies to ETFs that trade or hold gold. As a collectible, if gain is short term, then it is taxed as ordinary income.

If gain is earned over a period spanning more than one year, then it is taxed at capital gains rates, depending on the investor’s income tax bracket. This means that investors cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold for shorter-term investment.