Investment Primer: The Currency Composite

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What, Why, and How of Currency Funds

The Currency composite includes funds that provide exposure to the foreign exchange (forex) market, allowing investors to take a position on the value of one currency relative to another. The “why” for investing in currency funds is typically for one of three reasons: to speculate on the direction of a currency, to hedge against currency risk in an international portfolio, or to add a source of returns that is uncorrelated with traditional stocks and bonds.

The “how” is achieved almost exclusively through the use of derivatives. These funds do not typically hold physical currency but instead use futures or forward contracts to gain their desired exposure. The strategies are generally straightforward, aiming to track the performance of a specific currency (like the U.S. dollar) against a basket of others, or to capture returns from specific currency-based strategies like the “carry trade.”

Deconstructing Currency Strategies

The strategies within the Currency composite are distinct and designed for different market views and portfolio roles.

  • Directional U.S. Dollar (Long & Short): These are the most common currency funds. They are designed to track the performance of the U.S. Dollar Index (USDX), which measures the value of the U.S. dollar against a basket of six major world currencies (the Euro, Japanese Yen, British Pound, etc.). A “bullish” or long fund (like UUP) is designed to go up when the dollar strengthens, while a “bearish” or short fund (like UDN) is designed to go up when the dollar weakens.
  • Emerging Market Currency Basket: These funds provide exposure to a diversified basket of currencies from emerging market countries. An investment in a fund like this is a bet on the collective strength of these currencies against the U.S. dollar, often driven by the long-term economic growth prospects of those nations.
  • Currency Carry Trade: This is a more complex, actively managed strategy. A carry trade involves borrowing in a currency with a low interest rate (the “funding currency,” historically the Japanese Yen) and investing in a currency with a high interest rate (the “target currency”). The goal is to profit from the interest rate differential, or “carry.” The primary risk is that a sharp appreciation in the funding currency can wipe out the gains from the interest rate spread. Some funds may use options to hedge against this risk.

A Practical Guide to Locating Funds in the ETF Action Database

ETF Action’s classification system allows users to efficiently find the specific currency exposure they are looking for.

3.1 Foundational Screening: Building the Initial Universe

  • Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
  • Step 2: Filter by Asset Class. Select Asset Class = Currency.
  • Step 3: Filter by Composite. Select Composite = Curr: FX.
  • Step 4: Filter by Group. This is the key filter to distinguish the main strategies:
    • Long: USD or Short: USD for directional bets on the U.S. dollar.
    • Long: Emerging for exposure to a basket of emerging market currencies.
    • Long | Short: Multi for carry trade strategies.

Advanced Filtering: Refining Your Peer Group

  • Brand (Issuer), AUM, Expense Ratio, Liquidity: Use these standard filters to narrow the list to viable candidates. High liquidity (trading volume) is particularly important for these tactical trading instruments.

A Framework for Evaluating Currency Funds

Evaluating a currency fund requires an understanding of the macroeconomic factors that drive exchange rates and the specific mechanics of the fund’s strategy.

Risk/Return Analysis: The Importance of Benchmarks

The foundational step is to analyze a fund’s historical risk and return profile. ETF Action assigns a Beta Tracker to the category (typically UUP, the U.S. Dollar Bullish fund) to provide a relevant peer for comparison.

  • Total Return: How has the fund performed over various time periods? For directional funds, this should be compared directly to the movement of the underlying currency or index.
  • Standard Deviation (Volatility): Currency markets can be volatile. It’s important to understand a fund’s volatility relative to its peers and other asset classes.
  • Sharpe Ratio: Did the fund provide better risk-adjusted returns?

Quantitative Analysis

  • Tracking Error: For passive funds designed to track an index like the USDX, how closely does the fund’s performance match the index’s performance?
  • For Basket Funds: Look-through analysis is not about stocks or bonds, but about the underlying currency weights. What is the fund’s percentage exposure to the Chinese Yuan versus the Mexican Peso or the Indian Rupee?
  • For Carry Trade Funds: The return comes from two sources: the interest rate differential and the spot currency movement. It’s important to understand both drivers. The fund’s performance should be evaluated based on its ability to generate positive returns with low correlation to other assets.

Qualitative Analysis: Evaluating the Strategy

  • Macroeconomic View: Currencies are driven by macroeconomic factors. An investor using these funds needs to have a view on interest rate differentials, central bank policy, inflation, and economic growth prospects for the relevant countries. These funds are tools to express that view.
  • Strategy Mechanics: For a carry trade fund, what are the specific currencies being used? How does the manager hedge against the risk of a sharp reversal? For a futures-based fund, what is the methodology for rolling the futures contracts?
  • Structure: All funds in this composite are Derivatives-based, meaning they use futures or forward contracts. It is essential to understand the risks associated with these instruments.

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