Currency ETFs: Investing Around the Troubled Dollar

We recommend holding a diversified basket of currencies in the liquidity portion of a portfolio for experienced investors.

The Dollar just can’t seem to do anything right recently. The EURO is as expensive as it has ever been for those of us based in US Dollars. It takes far fewer Japanese Yen to buy a Dollar than not long ago.

Major currency reserve surplus countries, the largest of which is China, are taking action or talking about taking action to diversify their currency reserves beyond Dollars — reducing demand for Dollars.

Some oil producing countries are considering pricing oil in other currencies, Russia being at the front of that line.

Investors and currency traders see falling US interest rates relative to other major currencies, creating negative carry or reduced carry for being long Dollars.

Then there are the concerns about US deficits.

All of these things have been squashing the Dollar, as the following forex charts show.

The EUR/USD shows it now costs over $1.50 to buy one Euro. It was once less than $0.90.

[click to enlarge]

The USD/JPY chart shows that it takes only about 105 Yen to buy $1.00, compared to approximately 124 Yen to buy $1.00 less than a year ago.

[click to enlarge]

These changes in the exchange value of the Dollar have a huge impact on corporate results — who or what wins and who or what loses. Companies most able to manage their currency exposure by financial or operational means will fare best.

Even though we all have currency risk no matter what we do — whether we do nothing or do something — we think taking direct currency exposures within the liquidity portion of a portfolio makes sense.

You can create and manage currency exposure as an investor or trader through forwards, spot forex, currency futures, futures based funds and trusts or funds that hold bank deposit accounts in different currencies.

You can be exotic with minor currencies, but a reasonable approach would involve the three key currencies (U.S. Dollar, Japanese Yen and Euro).

For ourselves, we prefer to use spot forex positions due to the lower costs compared to investment funds of any type. Currency forwards are even less costly, but take a lot a capital. Spot forex has no management fee and very low bid-ask spreads for major currencies.

For spot forex you would open a forex account with a major bank such as Deutsche Bank. We would urge you not to open an account with a forex broker. Forex accounts are not insured, and you want the most substantial institution to hold your funds that you can find.

Minimum positions for spot forex can be too much for some investors, and there is an inconvenience factor of having a separate account and the associated paper work. There is no term or expiration on forex positions which roll over daily and earn bank overnight rates.

You could trade in currency futures, but that can be expensive and you need to roll your positions which is an administrative burden and a repetitive expense. That involves a separate account too.

For those who are willing to incur the substantially higher costs of bid-ask spreads and fund management expenses, but with the convenience of using existing stock brokerage accounts, there are ETFs and ETNs to consider.

The currency ETNs ((ERO) for the Euro, and (JPY) for the Yen, for example) no longer present the tax advantage they once held out as available, and they do have counterparty risk, so we’d avoid them.

The currency ETFs, are of two types:

• Trusts that hold the currency in bank deposit accounts and payout monthly ((FXE) for the Euro, and (FXY) for the Yen, for example). Between the 40 basis point expense ratios and the bid-ask spreads, these represent an expensive option.

• Entities that invest in currency futures ((UUP) for a Dollar bullish position, or (UDN) for a Dollar bearish position) invest in futures that are based on the US Dollar Index, which is a trade weighted index of the key currencies with which the US has international trade. They too have bid-ask spread costs and an approximate 55 basis point expense ratio.

There are some taxation issues to consider that are beyond the scope of this article and on which we are not qualified to advise. There is a helpful website you might want to consult for background before you ask you own tax adviser which of two basic options to elect for taxation of your currency investments (run by Green Company CPAs).

We recommend considering currency positions within the liquidity allocation of portfolios for experienced investors.

Comments

[User 159858:]

I actually think exposure through futures might be cheaper. If you do spot, the bank/brokerage usually takes quite a big cut on the overnight interest differential.

2008 Mar 11 11:43 AM

[d13:]

No way. The roll in the futures market would kill you. Futures don't pay any interest and force you to pay the taxes even if you haven't closed your position. CurrencyShares are investments that people should hold long term to balance their portfolios.

2008 Mar 15 07:14 PM

[ry:]

d13, um....you can earn a tbill rate on you margin in any futures account. rolling once a year hardly kills anybody.... taxes are 60% long term on futures, no matter your holding time. This is better than stocks....

2008 Mar 25 01:38 AM

[silver-bullet:]

Buy Chinese yuan, Swiss franc, New Zeland dollar etc. through EverBank.com, and avoid paying capital gains tax altogether when the currency appreciates against the US$ - which seems like a long term trend.

2008 Apr 18 12:34 AM

[alenka:]

Hi Silver-bullet, I am new to this...Can you explain you avoiding capital gain tax idea? You should pay income tax then?

On Apr 18 12:34 AM silver-bullet wrote:

> Buy Chinese yuan, Swiss franc, New Zeland dollar etc. through EverBank.com,
> and avoid paying capital gains tax altogether when the currency appreciates
> against the US$ - which seems like a long term trend.

2008 Nov 26 07:48 PM