A rising number of exchange traded fund (ETF) investors are looking toward currency ETFs as a way to diversify from the greenback, seek safe havens or implement other sophisticated currency strategies in their investment portfolio.

Before ETFs began covering the currency market, foreign currencies were limited to the foreign exchange market, or forex market. The forex market is the most liquid financial market, as it is backed by trillions of dollars in world currencies, continually exchanging hands across all time zones. Additionally, the effects of currency moves can often reverberate in other asset classes such as stocks. Foreign currencies are not actually bought or sold on a physical exchange. Instead, banks, corporations and individuals enter agreements on trades, with a majority of trades handled between banks.  [ETF Trends’ Guide to Currency ETFs.]

Forces Behind Currency Movements

Currency traders have to carefully monitor yields when trading in currencies. If a country’s benchmark bond yield decreases, the country’s domestic currency will most likely rise – currencies have a high inverse correlation to bond yields. Since the overall stock market and bond yields generally have a positive correlation, currency ETFs could act as a portfolio diversifier as a way to offset potential losses from drops in bond yields or broad equity markets.

In addition, a country that generates a significant proportion of GDP from raw materials or commodity exports will also see its currency’s strength oscillate, depending on commodity prices. For instance, the Australian dollar has a high correlation to base-metal prices due to the country’s large mining industry and its copious raw materials exports.

Currency ETF traders may also be interested in safe-haven currencies during troubled times. Political stability, low inflation and monetary and fiscal policies are all attributes that can make safe-haven currencies attractive. The U.S. dollar, European euro, Swiss franc, British pound sterling, Canadian dollar, Japanese yen and Australian dollar, have been categorized as safe-haven currencies. [Swiss Franc ETF Hits Fresh Peak on Debt Jitters.]

Recently, the euro lost some of its appeal as the financial problems of the Eurozone continue to hit the headlines, and the U.S. dollar has also come under fire as loose monetary and fiscal policies help extend the U.S. deficit; not to mention the debt ceiling debate. In contrast, fiscal and monetary prudence has helped countries like Switzerland and Japan maintain their strong currencies. [Dollar ETFs in Focus as U.S. Debt Talks Falter.]

Looking into Currency ETFs

ETFs offer the average retail investor a chance to gain exposure to foreign currencies. Prior to the launch of the first currency ETFs, the individual investor would have to gain access to this asset class through the forex market, and most individual investors do not have the resources or capital required to enter this market. Through ETFs, anyone may buy and sell currency holdings like stock shares. Potential currency investors now have a wide array of currency ETF or exchange-traded note (ETN) options available.

Currency ETFs provide non-U.S. dollar exposure and offer diversification and hedging through the use of another asset class, which may also allow an investor to reduce overall risk while maintaining a position to benefit from the potential upside.

Currency ETFs can try to reflect the performance of a single currency or a basket of currencies. Fund sponsors structure their currency products to try to mimic foreign currency movements by holding the targeted foreign currency or currency denominated short-term debt; however, it should be noted that fund structures vary between different fund providers and their management styles.

For example, Rydex’s CurrencyShares are grantor trusts that hold the actual currency. The interest earned is accrued on a daily basis and then reinvested monthly.

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