Everyone by now has heard of stock ETFs – securities that represent indices or bundles of stocks like funds but are traded on exchanges like stocks. Did you know, though, that in addition to these and other well-known types of ETFs, like commodity ETFs and bond ETFs, you can also find exchange-traded funds that represent currencies?
It’s true – and there are plenty of opportunities to trade a Euro currency ETF, emerging markets ETF, or other fund for virtually every major currency and currency group in the world. Here, I’ll cover how these ETFs work and how you can take advantage of them for your own portfolio.
What is a Foreign Currency ETF?
A foreign currency ETF, commonly known as a forex ETF, is a fund that represents the value of an underlying currency and can be bought and sold just like a stock on the open exchange. Just like a technology ETF covers stocks in the technology sector, forex ETFs are designed to give you a return based on the value of a particular currency.
This is accomplished one of two ways. First, a foreign currency ETF may be based on the exchange rate between one currency and another currency, which together is called a currency pair.
The second way is for a forex ETF to be valued based off the collective value of a specific currency. The PowerShares DB US Dollar Index Bullish Fund (UUP) is based off the U.S. dollar index (USDX), which tries to track the approximate strength of the U.S. dollar compared to a basket of currencies including the euro, Pound, Yen, Canadian dollar, Swedish krona, and Swiss franc. Since you can’t really invest directly in an index like USDX, UUP is there to give you a chance to trade the strength of the dollar. Since UUP is bullish, it is positively tied to the performance of the dollar; i.e., whenever the dollar is strong, so is UUP.
Benefits of Trading Forex ETFS
Why trade an ETF instead of actually trading currencies, though? After all, there are plenty of online brokerages that offer the chance to buy and sell forex options.
One key advantage to using foreign currency ETFs is that you gain a bit of insulation from the wild ups and downs of the foreign currency market. Forex options are notoriously speculative; foreign currency ETFs are less speculative and give you the chance to smooth out your exposure to the swings of one specific currency by investing in a broader, ETF currency basket.
Another advantage is that this particular type of ETF can give you the chance to play in the forex market without having to stick to just one currency pair. You can actually trade based on the value of several currencies or groups at once. For example, the WisdomTree Dreyfus Emerging Currency ETF (CEW) is an ETF that covers 12 different emerging markets. These markets include countries China, India, Mexico, South Africa, and Turkey. Since these markets are emerging and in some cases expanding rapidly, you can profit off the impact this growth has on these economies. Two particularly hot ETFs are Brazilian currency ETFs and Chinese currency ETFs.
Yet another common use of foreign currency ETFs is to get a gauge on U.S. markets. Even if you don’t actually trade them, you can still use them as an indicator in some cases for what markets in the United States will do. Australian currency ETFs, for example, are common leading indicators for American stock markets. The relationship isn’t perfect, but there’s definitely a correlation there that savvy investors use as a part of their overall approach to predicting the market.
Finally, you can use leverage to gain more of a return on your investment. A leveraged currency ETF is one that offers higher returns on your investment than you’d get normally. Ordinarily, it’s a 1-to-1 return; for every one unit that goes up, you gain one unit of return. The ProShares Ultra Euro (ULE) gives you double the return you’d get normally for any positive gain in the euro. The opposite – the ProShares UltraShort Euro (EUO) – is an inverse currency ETF because it gives you double the return for any drop in the euro’s value. You can find the same for US currency ETFs, too.
Hedging With ETFs
ETFs in general can be good hedging tools, and foreign currency ETFs are particularly useful in this regard. Since a lot of traders are tied up in the U.S. stock market or the U.S. dollar, any hit to either of those institutions impacts the trader’s bottom line. One way to mitigate losses is to use foreign currency ETFs to hedge against falls in the dollar or the U.S. markets.
So, if you are exposed to downside risk with the dollar or with U.S. markets, turning to an ETF like LNOK may be a good idea to reduce your exposure.