ETFs (Exchange Traded Funds) continue to grow in popularity as investors are looking to enter new asset classes to find new opportunities. There are many varieties including Fixed Income, Commodity, Equity, Volatility and the type in focus here – Currency. Markets have become increasingly more global and around the clock, which has driven growth in currency ETFs.
ETF Basics
First let us review the basics of the ETF. An ETF is by definition a basket of securities that operates under one ticker. The ETF will have a net asset value (NAV) and an intraday indicative value (IIV) as its two fundamental sources of valuation. Every day after the market close, the NAV will be calculated based on the close prices of the holdings and the cash available within the fund. The IIV is calculated at 15-second intervals throughout the trading day as a way to track where the fund’s price is relative to its theoretical value. 15 seconds is now entirely too long of a time period in finance so many of the large market makers calculate the IIV in real time to find places for arbitrage. The valuation will be much more complicated in non-FX ETFs as they hold a variety of assets.
Currency ETFs
Let us look at the CurrencyShares Euro Trust ETF (NYSEARCA: FXE). This is one of the more popular offerings in the market; especially considering the daily turnover in the EUR/USD is the most out of any currency pair. Say tomorrow you want to go long the EUR/USD, but you do not have a spot FX account or access to futures. The simplest way would be to go long FXE in your brokerage account. Each share of FX is equivalent to 100 euros and this is very important to understand in relation to our next subject – creation/redemption.
Built into ETFs is a creation and redemption mechanism that helps to ensure that the ETF does not stray too far from its theoretical value. In the event that a large mutual fund manager is starting to buy some European equities and wants to hedge against some of their currency risk, they might look to sell short FXE. Remember that to own foreign equities you must first buy the native currency and in this case euros. This allocation exposes you to fluctuations in the exchange rate and in this example is the reason the fund manager wants to remove the FX risk via hedging. Well in the event that they sell short FXE too aggressively, this will mean that the theoretical value (based on the NAV or IIV) of the ETF will be under what the exchange rate dictates it should be. This is known as trading at a discount. ETF’s can also trade at a premium as well. When the discount/premium becomes significant enough of a market maker, it will start the creation/redemption process depending on the scenario.
When FXE is trading at a premium, the market maker will buy up the equivalent amount of euros and exchange them with the sponsoring firm for shares of FXE. After the “creation” is done, they are able to sell the newly minted shares on the open market for a profit. When FXE is trading at a discount, the MM will buy shares on the market and deliver them to the sponsoring firm in the redemption process. They in turn receive euros and can sell them in the Spot FX Market for a profit. It is important to note that ETFs can often be illiquid so institutions must be very careful about buying or selling too fast or they will eliminate the arbitrage opportunity altogether.
Volatility and Liquidity
One thing that must recognized before trading any currencies is the volatile nature of the market. FX moves are often violent and correlations can frequently change. In 2008/2009 there were moments when the correlation between the USD and the US indexes were very close to -1. As we moved into 2010 and 2011 that relationship broke down as money flowed into stocks and the USD simultaneously. If you use FX ETFs for hedging or speculating on moves you must understand that the relationship will change. As proof the two major dollar funds UUP and UDN saw up to 10 times the volume in 2008/2009 than they currently do in the market today.
Getting back to the fundamentals of the product ETFs offer better liquidity than the traditional mutual fund yet it sometimes can be very poor on its own. Recently, a lot of major brokerages have offered commission-free trading on ETFs to push order flow and improve liquidity in the products. Despite this, you also lose the inherent leverage (25:1) in FX, which can hamper investment managers from allocating as much capital to equity investments. Spreads have been improving since the products have hit the market.
Conclusions
Like the mutual fund industry, there are a variety of companies to choose from for a similar product. Always pay attention to the expense ratio and whether leverage is involved before choosing any ETF as an investment decision. The expense ratio is the percentage that the manager charges in order to run the fund, and this typically goes to pay commissions and fixed expenses within the firm. Dealing with leveraged ETFs is another issue by itself. The purpose of ETN’s, which are very similar to ETF’s, like DRR (the Market Vectors Double Short Euro) is that they attempt to double the intraday performance of a similar short euro ETF. The method by which they attempt to double the performance is primarily done by futures and options. However, because of this these ETFs often do not track the underlying assets at all and are often much more volatile. As a new investor these should be avoided until you find a legitimate use for them. Similarly. an item to pay attention to with ETFs is the tracking error, though because of the nature and simple composition of the FX products this is usually not an issue.
Currency ETFs are still in their infancy, but continue to see adoption by investors across the world. Markets will continue to open and before long you might find yourself buying an ETF backed by the Nigerian Naira.
List of Popular (More Liquid) Currency ETFs:
- Australian Dollar – FXA
- British Pound – FXB
- Canadian Dollar – FXC
- Euro – FXE
- Japanese Yen – FXY
- Swedish Krona – FXS
- Swiss Franc – FXF
- Dollar Bullish – UUPDollar Bearish – UDN