ETF Plays For A Falling Dollar: Part II

by on November 4, 2009 | ETFs Mentioned:

Each new day seems to bring more downward pressure for the U.S. dollar, an unwelcome development for some investors who have seen the greenback slide near the $1.50 level against the euro in recent months. On Tuesday, two very powerful forces in the global economy expressed their doubts on the dollar’s future prospects: Warren Buffett and India’s central bank.

Weakness In The U.S. Dollar Have Investors WorriedBuffett’s Berkshire Hathaway announced the acquisition of railroad company Burlington Northern Santa Fe, a move many analysts viewed as a prediction of a falling dollar. Since commodities are priced in dollars (even outside of the U.S.), a weak dollar generally translates into reduced effective prices for foreign buyers, which in turn causes a rise in prices. Higher commodity prices benefit a number of parties, including the railroads that transport them.

Separately, the International Monetary Fund announced that it has sold 200 tonnes of gold to India for about $6.7 billion, representing an increase in the country’s bullion holdings of more than 50%. Earlier this year, China publicly indicated its preference for boosting its foreign reserves by accumulating hard currency over the U.S. dollar, and it appears that India has now followed suit.

Currency Baskets

Earlier this week, we took a look at the various commodity ETFs available to investors looking to profit from (or hedge against) a further slide in the U.S. dollar. Today we take a look at another option for investors concerned about a depreciating greenback: the PowerShares DB U.S. Dollar Index Bearish Fund (UDN), an exchange-traded product that offers exposure to a basket of developed market currencies.

The mention of an investment in currencies sets off alarm bells for many investors who liken the activity to being thrown into the shark tank – along with the sharks. Relatively small movements in exchange rates are generally amplified significantly by the leverage used in the forex accounts of most sophisticated investors, perhaps contributing to the notion that all currency investing is an extremely speculative activity.

But this isn’t the only application for this asset class.

In fact, traditional unleveraged investments in currency actually exhibit very low volatility. The dollar’s recent “freefall” against the euro has seen the price slide from about 0.80 EUR to 0.68 EUR, a drop of about 15%. When compared to the 55% drop in the S&P 500 between October 2007 and March 2009, the battering the dollar took seems like a minor loss.

Currencies are working their ways into the portfolios of more and more investors, in part due to their potential for reducing overall volatility. “If used properly, currencies can be another asset class that can provide diversification benefits in a portfolio,” says Ed McRedmond, Senior Vice President of Portfolio Strategies at Invesco PowerShares. And there is historical data to support this claim: over the last two years, UDN has displayed very weak correlations with other major asset classes:

ETF Correlation
SPY 0.26
BND 0.16
VNQ 0.22
Source: AssetCorrelation.com

Under The Hood Of UDN

UDN is based on the Deutsche Bank Short U.S. Dollar Index (UDSX) Futures Index, a rules-based benchmark composed solely on short USDX futures contracts. These futures contracts are designed to replicate the performance of being short the U.S. dollar against a basket of six major currencies. The composition of the USDX futures contracts as of November 2 is presented below:

USDX Futures Contract % UDN
Euro 57.6%
Japanese Yen 13.6%
British Pound 11.9%
Canadian Dollar 9.1%
Swedish Krona 4.2%
Swiss Franc 3.6%

While currency investing has traditionally included single country bets – such as a bet on a rising euro or falling yen – there are a number of ETFs now available that offer exposure to a diversified basket of currencies. For those convinced that the market has overreacted and punished the U.S. dollar too severely, PowerShares also offers a U.S. Dollar Bullish Fund (UUP) that takes a bull position in the dollar relative to its major rivals.

Just as diversification across asset classes reduces volatility of a portfolio, the “basket” approach to currency investing can smooth out bumps in a particular fund. “UUP and UDN allow investors to play the general trend of the U.S. dollar – either up or down – through an investment in a basket of currencies,” says McRedmond. “Investing in a basket of currencies can provide exposure to a longer-term trend in the dollar without the volatility of an investment in a single currency.”

A Look At Volatility

The following chart compares UDN’s price to those of three single-currency ETFs offered by Rydex, the CurrencyShares British Pound Trust (FXB), Japanese Yen Trust (FXY), and Euro Trust (FXE). The performance over the last two years shows two interesting patterns: 1) UDN maintains a strong correlation to the value of the euro, and 2) by holding a basket of currencies, UDN experiences much lower volatility than single currency funds.

UDN

A Popular Option

UDN has seen its popularity surge in recent months along with its price. The fund has taken in about $185 million in cash since the start of the year, and is up almost 15% for 2009. With a very reasonable expense ratio of 50 basis points and a number of possible uses – including both hedging and speculation – this fund has become a valuable tool for an increasing number of investors.

Disclosure: No positions at time of writing.