In Focus: Currency ETFs

But until recently, currency trading remained solely the domain of major financial institutions or international corporations, due to the huge costs, high minimum trades and over-the-counter nature of the “forex” market.

Not anymore. New currency ETFs and ETNs have made it easier than ever for individual investors to explore currency exposure. Since the 2006 launch of the first currency exchange-traded product (ETP), Rydex's CurrencyShares Euro Trust (NYSE Arca: FXE), 35 additional instruments have been unveiled.

Of course, with assets under management totaling just $7.084 billion, currency products still represent a very small portion of the exchange-traded fund universe. But as investors increasingly seek ways to hedge risk associated with dollar-denominated holdings and flesh out their international exposure, currency funds are gaining popularity at a quickening pace.

The Types of Currency ETPs

Most single-currency ETPs simply reflect the exchange-rate fluctuations between a given currency and the dollar, along with any interest income accrued from the underlying local market. That makes these funds essentially identical to simply holding foreign currency in a bank account (just as investing in the SPDR Gold Trust (NYSE Arca: GLD) is equivalent to holding physical bullion). The aforementioned FXE and the rest of the CurrencyShares family are structured in just this way.

Other single-currency ETFs, like the PowerShares DB U.S. Dollar Bullish (and Bearish) ETFs (NYSEArca: UUP and NYSEArca: UDN, respectively), instead hold futures contracts that track a given currency or currency-based index, such as the U.S. Dollar Index. Still others, like the WisdomTree family of currency ETFs, invest in foreign-denominated money markets instead, or use currency forward contracts to gain exposure.

There are also a handful of multiple-currency ETPs on the market, including three emerging market currency ETNs from Barclays and the WisdomTree Dreyfus Emerging Currency Fund (NYSEArca: CEW). CEW tracks a range of emerging market currencies by investing in U.S. money markets and local currency forward contracts.

Some products even help investors copy investment strategies common in the forex markets. For example, Van Eck and ProShares both offer leveraged currency ETPs that reproduce the highly leveraged positions used by forex traders. In addition, investors can replicate a long/short carry trade strategy through the iPath Optimized Currency Carry ETN (NYSEArca: ICI) or the PowerShares DB G10 Currency Harvest Fund (NYSEArca: DBV).

ETN vs. ETF?

One final note: Investors should carefully consider the structure of the currency product they choose, because not all currency vehicles are created equal. Options, for example, are only available for ETFs, not ETNs. What's more, under current federal rules, the interest earned by currency ETNs can be taxed—even though that interest is reinvested and not collected until the ETN is sold.

Given these differences, it's no surprise that the ETN structure has fallen out of favor for currency investors: As of Feb. 28, 2010, ETFs account for 97.8 percent of all assets under management in currency ETPs; ETNs make up just 2.2 percent.

Taxes

It’s important to remember that for virtually all currency ETPs, any gains (as well as interest income) from the funds will be taxed as ordinary income, regardless of how long you hold the fund. You could hold FXE for five years: When you sell, any gains would be taxed as ordinary income, not long-term capital gains.

The only two exceptions to this are the WisdomTree Dreyfus Euro (NYSEArca: EU) and WisdomTree Dreyfus Japanese Yen (NYSEArca: JYF) funds. Because these funds access the currency space through money-marketlike securities, they’re taxed like traditional bonds funds. If you hold these funds for a year or longer, gains will be taxed as long-term capital gains.