McCabe points out that currencies are non-correlated assets. “The risk you have oftentimes is performance vs. the underlying currency you’re purchasing in.”

As an example, assume that $1 equals 1 yen. If the dollar increases in value, you might get 1 yen for 90 cents – great if you’re traveling to Japan when this happens. However, it’s not so great if you have an asset priced in yen that you bought when dollars and yens were of equal value.

The flip side also works: if the dollar falls against various currencies, you stand to make money on assets based in those currencies if you bought them before the dollar weakened.

When searching for currencies to invest in, McCabe looks at the country behind it. Political upheaval can wreak havoc on a currency.

“I would look for a stable country with strong jurisprudence and rule of law…a country you believe is going to be stable, in case of turmoil.”

Why Use ETFs Instead?

Investing in currencies on your own, without an ETF, can be an arduous task. The currency market is one that never closes. Twenty-four hours a day, trillions and trillions of dollars in trades are taking place. You could find yourself sitting up in the middle of the night, waiting for a key signal to pounce on a trade.

That probably doesn’t sound like the average retail investor’s idea of a good time.

There are now two options for exchange traded currency investing: ETFs and exchange traded notes (ETNs).

Two key differences between currency ETFs and ETNs are:

  1. Currency ETNs (like all ETNs) are backed by the full faith and credit of the issuer. If the issuer goes under, you have to get in line with all the other creditors. It’s a small risk, but it’s one to keep in mind.
  2. Currency ETNs linked to a single currency are treated like debt for federal tax purposes, according to a 2007 IRS ruling. It means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the ETN is sold or upon maturity of the contract. It also means that investors can’t elect capital gains treatment.

Not all exchange traded currency products are structured in the same way, either.

McCabe points out that it’s wise to be aware of what makes currency products different from one another. For example, Rydex’s CurrencyShares funds are grantor trusts – they hold the actual currency.

The interest earned on them is accrued on a daily basis and reinvested monthly. This reinvested interest is then reflected in the fund’s net asset value (NAV).

On the other hand, PowerShares‘ currency ETFs, PowerShares DB US Dollar Bullish Fund (UUP) and PowerShares DB US Dollar Bearish Fund (UDN), hold futures contracts and are registered as open-ended ETFs. Any gains from futures contracts are subject to 60/40 tax treatment, in which 60% of the gains are long-term, 40% are short-term.

In the bullish fund, the futures contracts are designed to be long on the U.S. dollar against the euro, yen, pound, canadian dollar, Swedish krona and Swiss franc. The bearish fund is designed to be short on the U.S. dollar against those currencies.

WisdomTree‘s currency income ETFs invest in either non-U.S. moey market securities, or in a combination of money market instruments designed to provide exposure to non-U.S. money market securities or rates. They are not money market funds. They seek to give investors current income reflective of foreign money market rates available to U.S. investors, as well as exposure to changes in the value of a specific currency relative to the U.S. dollar.

Market Vectors‘ currency ETNs are senior, unsecured debt securities that give exposure to the exchange rate between U.S. dollars and foreign currencies. The underlying indexes are also affected by movements in interest rates in the country of the underlying currency and that of the United States’.

Market Vectors and ProShares also have some double long and double short ETNs for investors looking to enhance their exposure. They aim to double the daily performance of a specific currency. Know the risks of short and leveraged funds before you invest, however. They aren’t for everyone.

Barclays’ iPath currency ETNs measure the relative values of two currencies. In the EUR/USD fund, for example, when the euro rises against the U.S. dollar, the fund increases, and vice versa. The provider also has a currency carry ETN, iPath Optimized Currency Carry (ICI), that seeks to capture the returns potentially available from a carry trade. The pool of currencies the index may apply its strategies are known as the “G10” currencies, which includes the U.S. dollar, euro, Japanese yen, Canadian dollar and Swiss franc.

How to Choose

At this point, there are enough ETNs and ETFs targeting currencies that investors have a whole range of choices when it comes to figuring out how they want to play them. When choosing currency ETFs, consider the differences between the available funds, how they access currencies and their tax treatment. In short, know what you own.

Perhaps one of the easiest ways is via a broad basket of currencies, which help spread out the risk and lessen the blows a volatile stock market can deliver. Some examples:

  • Barclays Global Emerging Market Strategy [GEMS] Asia 8 Index ETN (AYT)
  • Barclay’s iPath Optimized Currency Carry Exchange Traded Note (ICI)
  • PowerShares DB G10 Currency Harvest Fund (DBV)
  • WisdomTree Dreyfus Emerging Currency Fund (CEW)

There are a number of single-currency funds available, as well, along with a number of others that are in registration:

  • PowerShares DB US Dollar Bullish Fund (UUP)
  • PowerShares DB US Dollar Bearish Fund (UDN)
  • CurrencyShares Australian Dollar Trust (FXA)
  • WisdomTree Dreyfus Brazilian Real Fund ETF (BZF)
  • CurrencyShares British Pound Sterling Trust (FXB)
  • iPath GBP/USD Exchange Rate ETN (GBB)
  • CurrencyShares Canadian Dollar Trust (FXC)
  • Market Vectors – Chinese Renminbi/USD ETN (CNY)
  • WisdomTree Dreyfus Chinese Yuan Fund ETF (CYB)
  • CurrencyShares Euro Trust (FXE)
  • iPath EUR/USD Exchange Rate ETN (ERO)
  • WisdomTree Dreyfus Euro Fund ETF (EU)
  • Market Vectors – Indian Rupee/USD ETN (INR)
  • WisdomTree Dreyfus Indian Rupee Fund (ICN)
  • CurrencyShares Japanese Yen Trust (FXY)
  • iPath JPY/USD Exchange Rate ETN (JYN)
  • WisdomTree Dreyfus Japanese Yen Fund ETF (JYF)
  • CurrencyShares Mexican Peso Trust (FXM)
  • CurrencyShares Russian Ruble Trust (XRU)
  • CurrencyShares Swedish Krona Trust (FXS)
  • CurrencyShares Swiss Franc Trust (FXF)

There are also leveraged funds, which enable investors to maximize the movements of a particular currency. The following funds all double exposure by 200%:

  • ProShares Ultra Yen ETF (YCL)
  • ProShares UltraShort Yen ETF (YCS)
  • ProShares Ultra Euro ETF (ULE)
  • ProShares UltraShort Euro ETF (EUO)
  • Market Vectors Double Long Euro ETN (URR)
  • Market Vectors Double Short Euro ETN (DRR)

In registration include CurrencyShares for Hong Kong, Singapore and South Africa, as well as WisdomTree funds for the Czech koruna, Chilean peso, Israeli Shekel, the Russian ruble and many more.

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

For more stories on currencies, visit our currency ETF category. For more special reports, view our special report page.

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