Index ETFs cover all sorts of asset classes: equities, bonds, real estate, commodities and currencies. And yes, exchange-trade funds have also cropped up to cover currencies, although this class of ETFs is likely the least well known among the ETF universe.
Currency ETFs track either the performance of single currencies or the exchange rate between two currencies. An ETF might be pegged to something familiar like the euro or the Canadian dollar, or something else like the Swedish krona, British pound, or Russian ruble.
As of 2008 currency ETFs accounted for approximately $3.3 billion of investment assets, with over two-thirds of these assets invested in the Rydex line-up of CurrencyShares funds. Their CurrencyShares Japanese Yen Trust (FXY) attracted $700 million in assets for example and also rewarded investors with good investment performance in 2008.
The CurrencyShares Euro Trust (FXE) made investment gains early in 2008 as the euro strengthened against the dollar. As 2008 progressed, the Euro shares dropped in correlation with the broader European ETF known as the SPDR DJ Euro STOXX 50 ETF (FEZ). To the extent that a stronger euro does hurt Europe's economy, then the FXE Euro shares might be an attractive investment for your portfolio.
Despite continued devaluation of the U.S. currency due to hyper supply and other monetary policy issues, the greenback has held up surprisingly well. This resilience may not be on account of strength in the U.S. dollar but, rather, due to relative weakness of other world currencies, and the dollar is of course the largest reserve currency in the world.
If you suspect a rally of the U.S. dollar against other currencies, then it makes sense to believe that the U.S dollar will gain value against the euro. If selling FXE in this scenario is not to your liking, consider buying PowerShares DB U.S. Dollar Index (UUP) instead.
FXY is the Yen ETF. While most markets lost ground in 2008, for example, the Yen Shares returned 20%. The strength of the yen currency has dampened Japan's economy, however; former growth stocks struggle as shown by the iShares MSCI Japan ETF (EWJ) as overseas revenues are converted into stronger yen. It is said that Toyota's operating profits are reduced by around $400 million per year for each yen gained versus the dollar.
An investment portfolio can be shielded against currency-induced economic distress by using currency ETFs. Adding FXY Yen shares to a portfolio mitigates weakness in Japanese stocks to some degree and can reduce the overall volatility of the portfolio.
Other country-specific ETFs include the U. K. (EWU), Germany (EWG), France (EWQ), Hong Kong (EWH), Taiwan (EWT), and Brazil (EWZ) among other developed and emerging markets. These ETFs can be important proxies for equity prices in these markets; since equity prices can affect currency exchange rates it is a good idea for the currency trader to at least monitor relevant equity market levels.
Exchange Traded Notes (ETN)
Market Vectors Double Long Euro ETN (URR) is one example of a fund that is really structured as a note and is therefore technically an ETN and not an ETF.
When investing in currency funds, be aware that currency ETFs can receive different tax treatment than currency ETNs. In 2007 the IRS issued an adverse tax ruling on currency linked exchange traded notes (ETNs) which are different from ETFs. ETNs are debt instruments and investors therefore carry the credit risk of the issuer. In times of financial turmoil, especially on a global basis, this default risk should definitely not be ignored or under-estimated.