7969 / 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.

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Planning Point: 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.

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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 advisable to 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 underlying ETF shareholder (as a result of the general tax rules that apply to grantor trusts). ETFs that are organized as grantor trusts 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.