In today's globalized economy, investors are increasingly seeking opportunities to diversify their portfolios beyond traditional stocks and bonds. Currency exchange-traded funds (ETFs) have emerged as a tool for individuals and institutions alike to gain exposure to foreign currencies. This article explores the concept of currency ETFs, delves into their benefits and risks, and provides three popular currency ETFs for readers’ reference.
What is a Currency ETF?
A currency ETF is a type of exchange-traded fund that aims to track the performance of a foreign currency against the U.S. dollar or a basket of currencies. These funds trade on stock exchanges just like stocks and are usually passively managed.
Currency ETFs are important because they are useful for hedging purposes. For example, in 2023, the Nikkei 225 Index in Japan gained 30% YTD, whereas Japan ETF EWJ gained only 13.8%. The difference was due to the value of the Japanese yen, which has depreciated against the U.S. dollar during the same period. Investors could protect their investment against such currency fluctuations by longing or shorting the relevant currency ETFs.
Benefits of Currency ETFs
Diversification: Currency ETFs can enhance a portfolio’s currency diversity, or can be used as a hedging strategy against the fluctuation and volatility of a particular currency.
Access to Global Markets: Currency ETFs allow investors to tap into international currency markets and speculate on currency movements.
Liquidity and Transparency: As exchange-traded funds, currency ETFs offer high liquidity, allowing investors to buy and sell shares throughout the trading day. Additionally, these funds provide transparency, as their holdings are disclosed regularly, enabling investors to make informed decisions.
Risks of Currency ETFs
Volatility: Currency markets are notoriously volatile, and exchange rates can fluctuate significantly in response to economic, political, or geopolitical events. Investors in currency ETFs must be prepared for potential losses due to currency depreciation, as well as the risk of sudden currency movements impacting the fund's value.
Currency Risk Amplification: While currency ETFs can be used to hedge against currency risk, they can also amplify it. If an investor holds assets denominated in a particular currency and invests in a currency ETF that tracks the same currency, a decline in the currency's value could result in losses on both fronts.
Limited Returns: Currency ETFs typically pay very limited dividends, if at all. The primary source of potential returns for currency ETFs is capital appreciation or depreciation. This characteristic makes currency ETFs more suitable for short to medium-term investment strategies rather than long-term income generation.
Examples of Currency ETFs:
Invesco CurrencyShares Euro Trust (FXE): This ETF seeks to track the price of the euro relative to the U.S. dollar. It provides investors exposure to the euro, the currency of 19 European Union countries, which can be valuable for those looking to invest in European assets or hedge against the euro's fluctuations.
WisdomTree Chinese Yuan Strategy Fund (CYB): This ETF aims to achieve total returns reflective of both money market rates in China available to foreign investors and changes in value of the Chinese Yuan relative to the U.S. dollar.
Invesco CurrencyShares Japanese Yen Trust (FXY): Similar to FXE, but this ETF tracks Japanese yen instead. This ETF offers exposure to the Japanese yen relative to the U.S. dollar, increasing in value when the yen strengthens and declining when the dollar appreciates.
Conclusion
Currency ETFs provide investors with an accessible way to participate in global currency markets, offering diversification and exposure to foreign currencies. However, they come with risks, including currency volatility and the potential for currency risk amplification. As with any investment, it is crucial to conduct thorough research and consider individual investment goals and risk tolerance.
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Currency View - a monthly series on currency trading
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Global Macro Playbook - a monthly series on global macro trading
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.