The Basics of Currency Linked Funds

Posted 08/24/2009, 9:00 am EST by Staff from ETFguide.com

Many investors are just beginning to appreciate the importance of currencies. Currency is a major asset class and offers the potential for capital growth. It can also act as a diversification tool to hedge against passive currency exposure. Also, movements in foreign currencies don�t always concur with local foreign stock or bond markets.


Currency Linked Trusts
Currency linked trusts are mainly designed to provide market exposure to foreign currencies. While investors can obtain currency diversification buying them, they can also get interest in the form of a yield based upon overnight interest rates in the country of the underlying currency. The amount of earned income will primarily depend on the relative value of the currency held by the trust and the U.S. Dollar.

Rydex Investments manages a series of trusts called "CurrencyShares" that aim to track the movement of single country currencies. The oldest of these is the Euro Currency Trust (FXE) which was launched in 2005. The CurrencyShares are designed to track the price of the underlying currency based on the Federal Reserve Noon Buying Rate, which is the exchange rate of the U.S. dollar into the applicable foreign currency.

Unlike traditional ETFs, which are registered under the Investment Company Act of 1940, most currency ETFs like the CurrencyShares are grantor trusts governed under the Securities Act of 1933. They�re created and redeemed in each respective foreign currency and they don�t use any leverage or derivatives. In the case of CurrencyShares, the actual currency is deposited within each trust and held at a secure depository managed by the London branch of JP Morgan Chase Bank.

While the product architecture of currency ETFs is considerably different from most stock and bond ETFs, they still trade in a similar fashion and can be purchased with regular brokerage orders. They can also be leveraged with margin, shorted or bought and held.


Currency Linked ETNs
Currency exchange-traded notes (ETNs) are linked to specific performance and yield of currencies. While the concept of currency diversification is same, the operational differences of currency notes compared to currency linked trusts are considerable.

ETNs are debt securities with a set maturity date and they do not usually pay an annual coupon or specified dividend rate. ETNs can be traded or redeemed before the maturity date. If the note is held to maturity, the investor is paid the return of the note�s underlying index, minus the annual expense ratio.

There are no investment guarantees with ETNs. For example, a note�s underlying index may not produce a positive return over the lifetime of the investment. And even if it does, there�s always the risk the ETN issuer won�t pay the return because of defaulting.

Unlike currency linked trusts, ETNs carry issuer risk which is tied to the credit worthiness of the financial institution backing the ETN. If the issuer�s financial condition deteriorates, it could negatively impact the value of the ETN, regardless of how its underlying index performs.


Tax Considerations
Currency Trusts: The profits from currency trusts are taxed as ordinary income and do not receive the benefits of lower taxes via long-term capital gains. The income is flowed through to each shareholder as if they owned a pro rata share of the currency assets held by a particular trust. Shareholders are required to recognize gains or losses when the trust converts the foreign currency it holds to U.S. Dollars to pay the sponsor's fee or to make distributions to the trust's shareholders.

Currency ETNs: In December 2007, the U.S. Internal Revenue Service issued an adverse tax ruling on currency linked ETNs. The rule stated that any financial instrument linked to a single currency regardless of whether the instrument is privately offered, publicly offered or traded on an exchange should be treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells any such financial instrument, including an ETN, or the contract, matures. It also means that gain or loss on sale or redemption will generally be ordinary, and investors will not be able to elect capital gain treatment. The IRS is expected to rule on the tax treatment of ETNs linked to commodities and stocks.