Rydex's CurrencyShares ETFs: The Expensive Truth

Over the past couple of 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 (FXE)

CurrencyShares Mexican Peso Trust (FXM)

CurrencyShares Swedish Krona Trust (FXS)

CurrencyShares Australian Dollar Trust (FXA)

CurrencyShares British Pound Trust (FXB)

CurrencyShares Canadian Dollar Trust (FXC)

CurrencyShares Swiss Franc Trust (FXF)

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 €74,900. 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%. span> He would still be going long €74,900, 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.

Comments

[garlicbulb]

One of the important aspect of ETFs is that they can be used by IRA accounts

[MikeV]

Well, 0.40 expenses is not unusual for what is effectively a money market fund. Bid-ask spread is another issue for traders, but for an intermediate-term hedge against the decline of the dollar the funds should work.

If I buy ofreign currency through the forex market, how do I get money market interest rates (from a UK bank, for example)? Not from the banks I have dealt with.

[sbenard]

There is still another alternative. One can trade currency futures. With futures, you are using an exchange, so the spread is much tighter -- usually only 1 tick (same as a pip). Most online futures brokers only charge you about $5 per trade. Thus, you can break even after the market gives you only 1 tick!
If a Forex broker charges an average of 3-5 ticks on the majors, trading the futures will save you $20-$40 for each transaction. The dirty little secret of Forex brokers is that they increase the spread to line their pockets.
The futures are extremely liquid, and during times of market turmoil following a news event (like the NFP jobs report), you will also get much better executions. I stopped trading Forex long ago, because the currency futures are much easier to make money with. There is no comparison!
I have written more about this on my own blog. Look at the second section that discusses how to save money on Forex.
globalcapital.blogspot...

[winkler]

Big deal! A 0.40% expense ratio is pretty reasonable considering the convenience offered by being able to simply buy an ETF in your regular stock account - IRA or otherwise. I'm sure the alternatives (FOREX or currency futures) are ultimately cheaper, but people don't have to open a whole new account to buy ETF's. And as an advisor, do you really think I want to go to all the trouble to get all my clients to open futures or FOREX accounts just to save a few bucks? Not to mention the amount of client education I'd have to do with most of them about how it's really "OK" to have a FOREX or futures account. Many clients simply won't hear of having such a "risky" type of account. Currency shares provide a great convenience and service. With these ETF's I can get exposure for myself and my clients that in many cases just wouldn't happen at all if it meant opening FOREX or futures accounts.

[toulousian]

Something that was touched on twice in this thread is that you can somehow get the interest with the FOREX acct. I don't see how you'd do that and that's a lot of the reason I'm in the Rydex Euros EFT. Also agree with the value of being able to buy and hold in my normal brokerage acct. Any answer for the interest question?