An exchange-traded fund (ETF) is an equity security that provides exposure to an index, a basket of assets, a commodity or an investment strategy. For those interested in forex trading, an ETF can grant exposure to one or more currencies through either direct holdings, investment in currency-denominated short-term debt securities or derivatives contracts.
Some retail investors opt for ETFs due to the perception that the funds offer low fees and high liquidity. However, other investors choose to work with alternatives, such as mutual funds or other equity securities.
Tracking Currency Markets
ETFs can track the movements of the currency markets using the aforementioned methods. In addition to obtaining exposure to the forex markets through direct holdings, these funds can use sophisticated strategies to achieve specific investment objectives. For example, some ETFs use futures contracts in an attempt to achieve their goals.
Fund managers have developed ETFs that make bets on whether the U.S. dollar will rise or decline relative to a basket of other major currencies. Forex traders might use these actively managed ETFs to hedge their currency positions.
Regardless of which approach an investor wants to use, ETFs provide numerous distinct benefits, as well as risks, and this article will delve into these so that readers are well-informed on the subject.
Benefits of ETFs
Some investors use ETFs to trade currencies instead of opting for other approaches, and the potential reasons for doing so are many. In many cases, these securities are passively managed, which means they seek to replicate an index.
Lower Fees: Because passively managed ETFs do not need a management team to pursue their objectives, they frequently have lower fees than their actively managed counterparts. Some investors prefer to use these funds because of their costs. However, other investors might opt to work with funds that are actively managed, for example mutual funds.
Investors should keep in mind that fee management can have a significant impact on final returns. In other words, lower fees can result in higher returns, whereas higher fees could potentially reduce returns.
Diversification: Some investors like working with ETFs because they can provide quick diversification. While ETFs track most international currencies, they can also grant exposure to long/short strategies that involve varying currencies.
Liquidity: ETFs trade like a stock, so their prices can fluctuate throughout the day on exchanges. This compares to mutual funds, which have their net asset value calculated at the end of every trading day. Because they trade like stocks, investors can long buy and short sell ETFs. In addition, a liquid market makes it easier to buy and sell these securities.
Forex traders considering ETFs should keep in mind that they only need to buy one share of an ETF in order to invest using that fund. As a result, ETFs frequently require a rather small initial outlay of capital.
Tax Advantages: ETFs frequently have lower portfolio turnover than other securities such as mutual funds and attempt to minimise capital gains distributions. Because of these factors, ETFs often generate less tax liability than comparable securities.
Transparency: Because ETFs are obligated to disclose their holdings every day, forex traders interested in these funds will have a good idea of exactly which assets they own.
Tracking Error: While ETFs carry benefits, they also come with risks. Some have criticised these funds for tracking error, meaning that ETFs might not always track their underlying index effectively. This particular problem can become even more pronounced when these funds use leverage. Leverage is a double-edged sword as it can significantly increase profits as well as losses. Trading on margin carries a risk of losses in excess of deposited funds.
Default Risk: Many ETFs use derivatives in an effort to achieve their investment objectives. One problem tied to derivatives is that because they represent a contractual agreement between two parties, one party could fail to make good on its contractual obligations.
Liquidity: Liquidity has frequently been brought up as a benefit of ETFs. However, some of these funds are more liquid than others, and an individual fund itself could be far more liquid at certain points than at others. For example, an ETF tied to a specific industry might have far less trading volume than a fund associated with a broader index such as the S&P 500.
Volatility: While some advocate ETFs as a good way to obtain greater diversification, investors must still watch out for volatility. If one of these funds, for example, invests in a particular currency instead of a basket of currencies, it might experience sharp fluctuations in value.
Those looking at forex trading might consider ETFs as a potential means of reaching their investment objectives. By working with these funds, they can potentially derive many benefits. However, investors have many options at their disposal. As a result, investors considering ETFs will benefit from conducting thorough due diligence and/or speaking with a financial advisor.
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Senior Market Specialist
Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.