Move Over CurrencyShares: PowerShares Launches Two Currency ETFs

PowerShares significantly expanded the currency exchange-traded fund market this morning, as trading began on the American Stock Exchange for the PowerShares DB US Dollar Bullish Fund (UUP) and PowerShares DB US Dollar Bearish Fund (UDN).

The ETFs, originally filed with the Securities and Exchange Commission in August 2006, offer exposure (for all intents and purposes) to the New York Board of Trade’s U.S. Dollar Index, or USDX. The USDX is the best-known measure of the value of the greenback against the broader global currency market. Its composition is shown below.

“A lot of people wanted directional exposure to the dollar,” said Kevin Rich, CEO of Deutsche Bank Commodity Services, which partnered with PowerShares to launch the fund. “There have been very few tools for investors to use in a securities account to achieve this exposure.”

Rich went on to say that he expects the bulk of demand to come from the retail market, as institutional investors can access the USDX directly using futures. But by securitizing this futures market, Rich expects to open up the dollar index to a broader audience. He also expect some hedge fund activity in the ETFs.

The funds will hold futures contracts in the USDX (long or short, depending on the fund) as their core asset. As with most futures-based ETFs, the Dollar Index ETFs will invest their collateral cash in 3-Month U.S. Treasuries. Based on current interest rates, PowerShares expects the funds to generate approximately 5.05 percent interest per year. That will more-than-cover the 55 basis point expense ratio, allowing the funds to pay out an estimated 4.5 percent annual dividend.

The prospectus for the dollar index ETFs is available here.

Compared To CurrencyShares
The obvious question traders are asking about these funds is how they compare to Rydex’s CurrencyShares, the first currency-focused ETFs to hit the market. Those ETFs, which boast over $1 billion in assets, provide one-for-one exposure to individual currencies: i.e., the Euro Currency Trust (FXE) provides exposure to the euro, the Swedish Krona Trust (FXS) provides exposure to the Swedish krona, etc. They pay interest based on local interest rates.

The full list of CurrencyShares is shown below.

There are three primary differences between the CurrencyShares and the new DB funds:

First, the obvious : The DB funds provide exposure to a mix of currencies, while the CurrencyShares are tied to individual markets.

Second: While both funds generate interest income, the amount differs. The PowerShares funds will yield approximately 4.5 percent after expenses, which currently compares favorable to all but the Mexican Peso (FXM) and Australian Dollar (FXA) CurrencyShares.

Third, and most importantly, taxes:

Like all futures-based investments, the PowerShares ETFs will be taxed as 1256 investments, meaning that all capital gains are marked-to-market at year-end. In other words, capital gains and losses cannot be deferred: the IRS will treat your investment as if you sold the fund on December 31 and realized the gains. 60 percent of those gains are taxed as long-term gains, while 40 percent are taxed as short-term gains. There’s no way to defer the gains into the future.

In contrast, the CurrencyShares won’t generate gains until you sell the ETFs, at which point, the regular equity-style capital gains rules will apply.

For taxable accounts, that difference could be very important.

(Both funds generate interest income, which is taxed for most investors as regular income.)

As always, check with your tax advisor.

Which Index?
One curious bit of inside baseball about the new funds is that, while they functionally track the NYBOT’s U.S. Dollar Index, PowerShares/DB don’t appear to be licensing the index from the NYBOT. That’s because, technically, the ETFs track something called the Deutsche Bank US Dollar Index – Excess Return (http://www.amex.com/amextrader/?href=/amextrader/tdrInfo/data/axNotices/2007/valert2007-03.html).

What’s the difference? The NYBOT’s USDX tracks the value of the dollar against the six global currencies, and the NYBOT offers a futures contract based on that index. The Deutsche Bank US Dollar Index tracks the value of a rolling position in that futures contract.