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I've got a couple of doubts about how currency ETFs work.

  1. How do they track the spot price? For example, I was checking the FX pair GBPUSD, I've seen:

The doubt here is, do the prices in the ETFs are somehow related to the spot price? or the actual price doesn't really matter, and all that matters is the % changed in the spot price that should be reflected in both ETFs?

  1. Which amount does an individual has to invest to fully hedge his portfolio in a foreign currency?

For example, imagine that I invest £4000 and buy american stocks in $. If I think that the GBP is going to appreciate I think I should hedge against that situation by going long GBP, isn't it?

But if this is the case, and following with the standard ETF above and with the leveraged 3x ETF, how many of those shares should I buy?

Do I need to simply divide the portfolio amount in GBP by the price of each ETF in GBP as well?

eg. 1 - ETF long GBP short USD, USGB.L = £48.50 = $74.60

£4000 portfolio / £48.50 = 83 shares

eg. 2 - Leveraged 3x ETF long GBP short USD, PUS3.L = £35.32 = $54.33

[£4000 portfolio / 3 (due to the leveraged)] / £35.32 = 38 shares

Many thanks!!!

  • To hedge against foreign currency risk you would use fowards/futures. Most leveraged ETFs are for day trading. – Ross Oct 23 '15 at 12:33
  • Not many individual investors have easy access to futures and forwards and they can be prohibitively complex to trade. Currency etfs (unlevered) can be a fine alternative. – rhaskett Oct 23 '15 at 20:58
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As you guessed, the returns of the currency etf are supposed to closely match the returns of the currency the price level is mostly irrelevant. The 3x leveraged etf is supposed to closely match three times the returns in the currency. So for example if the return of the spot was 2% the first ETF should return about 2% and the second about 3 times 2% = 6%. However, the numbers above are not exact for important reasons.

In this case and generally currency etfs do not hold the currency but hold currency futures, forwards or swaps designed to get you returns closely related to the currency return. They are designed this way as it is generally a better deal than the costs of just holding the cash, but this does mean that over long periods of time they will drift a bit sometimes in your favor sometimes not.

Leveraged ETFs use similar instruments and currency options as well. Tracking a leveraged index is much more challenging and generates very large costs which are passed on to the investor. It's not uncommon to see an index be flat but have both the leveraged long etf and the leveraged short etf lose a lot of money. This is why, as @PabTorre mentions, leveraged etfs are generally better for very short term investors.

Your calculations are correct on the amount need to fully hedge your investment. Though I wouldn't recommend using the levered etf for anything but the shortest term hedging. Also, it is worth considering whether the opportunity cost locking up money in currency hedging is worth it instead of say having investments across multiple currencies or using currency-hedged etfs (if available).

Edit for comment: Neither currency etfs or futures/forwards are particularly good for hedging as a individual investor. Institutions generally use futures and forwards but they often have to put down less than 10% of the value to start so they can cover 30k using only 3K or sometimes nothing. You can check your broker but I doubt this is anywhere near the case for most individual investors. Also, futures/forwards need to be rolled which adds a lot of complexity. For individual investors generally the best option for hedged equity is currency-hedged equity etfs where the do the hedging for you. Sorry for the USD-based example, GBP versions likely exist but check with your broker about liquidity.

  • Hi, I didn't know that the ETF price level was mostly irrelevant and was mainly tracking the percentage return. But if I am understanding these explanations correctly then, if you make a £30,000 investment from UK in GBP on American companies (that are traded in USD), does it mean that you need to have exactly the same amount of £30,000 to be able to fully hedge your investment via ETFs? If that's the case, it doesn't seem too doable, and I guess what you guys mention about futures might make more sense for individual investors in this situations, does it not? – mickael Oct 25 '15 at 17:58
  • Note that like ETF price level, stock price levels are largely irrelevant as well, it is the return that maters to an investor. – rhaskett Oct 26 '15 at 18:04
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Leverage ETF are build using derivative portfolios (with options or swaps). Because of this they suffer Theta decay and lose value over time. You can easily see this by looking at a yearly chart and finding 2 times separated by a few months where the price on the spot was the same. On the leveraged ETF you will see that the price on the later day is significantly lower. Because of this they are not a good replacement for spot currency positions when hedging, but they may be a good replacement for derivative positions that will suffer from theta decay anyway.

To find detailed information on how the portfolio that makes up the ETF is composed and how it tracks the price, look for the prospectus of that ETF. This document is given by the institution that packaged the ETF and it is often provided with other useful documents.

For example, this page has the prospectus for PUS3.L

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