Currency ETFs were one of the best performing asset classes for 2008. Taxation, default risk and tracking error could affect the performance. Here is the 101 on currency investing.
Only three classes of index ETFs were able to produce positive performance numbers in 2008. Short ETFs, bond ETFs and currency ETFs.
Currency ETFs pegged to the U.S. dollar and Japanese yen were able to buck the trend and end the year in positive territory. The CurrencyShares Japanese Yen Trust (NYSEArca: FXY) recorded a 22.87% gain while the PowerShares DB US Dollar Bullish Fund (NYSEArca: UUP) was up 4.9%. UUP reflects the strength of the U.S. dollar compared to other leading global currencies.
Ironically, the U.S dollar and yen did quite well despite domestic economic troubles. The broad U.S. stock market, represented by the S&P 500 (AMEX: SPY) and Dow Jones (AMEX: DIA), fell over 38% in 2008. In an effort to prop up financial institutions, the U.S. government is flooding the system with new money. In theory, this should devalue the dollar. Why is the dollar rallying?
A strong dollar explained
There are two reasons. The dollar is the “best house in a bad neighborhood.”Even though the U.S. economy is in shreds, other countries are doing even worse. China’s Shanghai Composite (NYSEArca: FXI) lost 62.5%, India’s Sensex (NYSEArca: INP) lost 52.1% while European markets (NYSEArca: VGK) gave up 46%.
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Even though the government is trying to flood the market with liquidity to resurrect lending, investors continue to lose money. According to some estimates, Americans lost over $10 trillion with bad real estate and equity investments. More dollars are getting wiped out than created, therefore the value of the remaining dollar increases.
Currency ETF vs currency ETN - taxation
Investors wanting to gain exposure to currencies need to be familiar with the available options. Currency exposure can be gained via currency ETFs and currency ETNs. ETFs differ from ETNs in their tax-treatment and credit risk. Certain ETFs may even differ from other ETFs in their tax treatment.
According to a December 2007 IRS ruling, ETNs linked to a single currency should be treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells the ETN or the contract matures. It also means that gains or losses on the sale or redemption will generally be ordinary, and investors will not be able to elect capital gain treatment.
Below is an excerpt from the ETF Profit Strategy Newsletter – Published on Dec 15, 2008
At the time, the Dow was at 8,565. It reached 9,088 before dropping below 8,000.
Market Meter
Short-Term:published on Dec 15, 2008 The Dow should claw its way towards 9,150 Mid-Term:published on Dec 15 2008 Extreme optimism above Dow 9,000 will draw the Dow towards 7,445 Alert on Jan 6: Sell signal! "Dow at 9,000 might be the high for 2009" Long-Term:>> Sign up to find out
Rydex’s suite of CurrencyShares are registered as grantor trusts. This is the same structure used by State Street Global for the SPDR Gold Shares (NYSEArca: GLD). Just as the SPDR Gold Shares own actual gold bullion, the CurrencyShares own actual foreign currency. The CurrencyShares Euro Trust (NYSEArca: FXE) holds actual euro’s in a U.S. dollar denominated custodial account.
The interest, ranging from 0% for the CurrencyShares Swiss Franc (NYSEArca: FXF) over 7.90% for the CurrencyShares Mexican Peso (NYSEArca: FXM) to 8.55% for the CurrencyShares Russian Ruble (NYSEArca: XRU), accrues daily and is reinvested monthly. The reinvested interest is reflected in the Net Asset Value (NAV) of the trust. CurrencyShares are taxed the same as individual stocks (short-and long term gains).
PowerShares’ suite of currency ETFs, which includes the PowerShares DB US Dollar Bullish Fund (NYSEArca: UUP), PowerShares DB US Dollar Bearish Fund (NYSEArca: UDN) and PowerShares DB G10 Currency Harvest Fund (NYSEArca: DBV) are registered as open-ended ETFs.
Unlike the CurrencyShares, the PowerShares ETFs hold futures contracts. The US Dollar Bullish Fund for example holds US Dollar Index (USDX) futures. The USDX futures contract is designed to replicate the performance of being long the US dollar against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
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Gains derived from futures contracts (such as held by the PowerShares currency ETFs) are subject to the 60/40 tax treatment. 60% of gains are considered long term, 40% are taxed as short term gains. Shareholders will receive a simplified K1 statement at the end of the year.
Currency ETFs vs currency ETNs: credit issuer risk
ETNs are registered as debt instruments that pay a return linked to the performance of a single security or index. As such, ETNs eliminate tracking error replication issues. Due to liquidity and "investablility" issues, certain indexes (i.e. commodity indexes) are tough to replicate. ETNs provide a “loophole” to circumvent such issues.
Unlike ETFs, ETNs do not have a claim on a separate trust of assets. ETNs are debt instruments issued by the backing bank and redeemable on a daily or weekly basis for the value of a promised index return minus expenses.
ETNs expose shareholders to the credit risk of the backing bank. If the bank declares bankruptcy, shareholders in an ETN have to queue up along with all the other debt holders to try to claim their share of the company's assets.
Once a moot point, in an environment where financial institutions are struggling, issuer risk is a concern that validates consideration. Three Lehman Brothers Opta ETNs have already been closed. Barclays PLC, the issuer of the iPath suite of ETNs had to dip into the British version of the bailout fund. The stock of Deutsche Bank, which backs 22 ETNs, suffered a 80% drop on concerns about its financial stamina (search currency ETFs and currency ETNs by issuer).
Unlike ETNs, Exchange-traded funds are legally set up as trusts separate from the banks corporations. The assets within these trusts cannot be touched during bankruptcy proceedings, as they belong wholly to the shareholders of the fund.
Just as farmers always keep an eye on the weather when planting, make sure to take a look at all the issues affecting your investments. You don’t want to sow your seed right before a torrential downpour.
Simon is the Co-Founder of ETFguide.com and worked as registered investment advisor (RIA) for 8 years. Simon holds a banking degree with honors from the prestigious German Sparkasse Bank. He grew up in Bavaria/Germany.
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