Over the past couple years Exchange-Traded Funds have been popping up quickly; first they appeared in the general areas of the market, and now they are moving into the niche markets. In the past year, Rydex has introduced eight new ETFs, known as CurrencyShares, into the market. These ETFs focus purely on currency.
* CurrencyShares Euro Trust (Ticker: FXE)
* CurrencyShares Mexican Peso Trust (Ticker: FXM)
* CurrencyShares Swedish Krona Trust (Ticker: FXS)
* CurrencyShares Australian Dollar Trust (Ticker: FXA)
* CurrencyShares British Pound Trust (Ticker: FXB)
* CurrencyShares Canadian Dollar Trust (Ticker: FXC)
* CurrencyShares Swiss Franc Trust (Ticker: FXF)
* CurrencyShares Japanese Yen Trust (Ticker: FXY):
According to the Rydex Prospectuses, the ETFs allow investors to buy into a trust denominated in the particular currency that bears interest according to that currency's particular interest rate.
These funds seem to hit the market at the perfect time--right at the turning point of further US Dollar depreciation. In the year and a half since the introduction of the CurrencyShares Euro ETF (FXE), the US dollar has depreciated roughly 13% against the Euro December 13, 2005, and the Euro fund has increased about 12.5% which reflected by this currency's pattern. Most investors would consider that a respectable return, especially with an asset class that historically has had little correlation to domestic equity returns.
Smoke and Mirrors
Rydex's CurrencyShares carry a .40% expense ratio for the privilege to invest in the particular currency. The expenses are paid out of the interest (if the interest rate exceeds the .40% expense ratio) that is received on the account; therefore, the investor is oblivious to the actual "cost" of ownership.
For instance, an investor feels that the Euro would be a good investment in the long run, so he/she takes a long position in CurrencyShares Euro Trust (FXE). Suppose that this investor wanted to buy $100,000 worth of Euro; today he would effectively be going long EUR74,900. The Euro is currently yielding 3.54%, which comprises the fund, and the .40% expense ratio would be deducted from the interest payments on the Euro currency holdings. While the investor is receiving about $3,540 in interest per year from the position, he is paying about $400 in expenses per year because of that .40%, leaving him with an interest gain of about $3,140 per year. According to the fund fact sheet, "Because CurrencyShares will be traded as securities, transaction costs will be substantially reduced compared to currency spot market transactions." This statement, however, is not true in all cases and is very misleading to investors who feel that currency would be a good holding in their portfolios.
The "Low-Cost" Alternative
Over the past few years, the emerging market of Foreign Exchange (FOREX) has been gaining a lot of recognition and respect, and many brokers today focus purely on trading in this new and up-and-coming global market, helping investors to easily reap the many advantages. The FOREX market is the most liquid market in the world, with about $2.7 trillion traded per day, and it is available to trade 24 hours a day.
If an individual investor were to take that same $100,000 long Euro position directly through a FOREX broker, he would be able to reduce expenses dramatically by about 98%. He would still be going long EUR74,900, but this time without the .40% expense ratio. The only cost to initiating the position is the spread cost, which on the major currencies is usually only one to five pips. In this case, the spread cost to initiate this position would be around $9.00, which would roughly be the same as the broker commission to buy into the currency ETF. After this initial cost, there are no further expenses for the investor to pay. The spread costs will differ among FOREX brokers; therefore, a trader should shop around for the best spread cost and interest rates.
If the investor were to take the position through the FOREX broker, he/she would be able to yield about 3.40% per year, which would give the investor roughly $260 more in interest than the CurrencyShares Euro Trust. The lower interest rate received of 3.40% is because on the currency transactions there is spread on the interest rate. The broker keeps this, which is similar to what banks do when they pay out interest on deposits and lend out money at a higher rate.
Another benefit that comes with investing directly through a FOREX broker is the ability to leverage the equity in your account. Each FOREX broker is different in the amount of leverage that an investor can use, but typically it is around 50 times the account equity. FOREX brokers offer this type of leverage because when trading currencies, an investor is effectively buying (investing) one currency and selling (borrowing) another simultaneously. In the above examples of going long the Euro, the investor is actually going short the US dollar. An investor should have a good understanding of the market before engaging in leveraged currency transactions; every investment should be an educated investment.
So, What's Your Point?
The Rydex CurrencyShares ETFs have extraordinarily high expenses considering the type of product they are offering and the relatively low barrier to entry into trading the actual product directly in the FOREX market. They are able to rebalance their currency holdings with little transaction expenses into an always very liquid market, which is often difficult for equity ETFs to do.
ETFs can be incredibly helpful. When comparing the total cost it would take for an individual investor to buy into the individual stocks that comprise the S&P 500, and the total cost to buy into a currency, it is easy to understand why there are ETFs for the former. But the latter, as shown above, has very little cost to initiate; a currency trade is fairly easy and inexpensive, yet the Rydex CurrencyShares ETFs charge more than four times the expense ratio than that of ETFs that trade the S&P 500. It's ludicrous!
The amazing fact about the CurrencyShares ETFs Family is that they now boast $1.7 billion in Total Net Assets in their eight funds. I guess it goes to show that in a booming market, people will buy anything, just as long as they hear the right pitch.