The Ailing US Dollar Index

July 07, 2011

The U.S. Dollar Index has been the go-to benchmark to value the dollar in other currencies since 1973. Too bad it’s so flawed.

Just as one would expect a plain-vanilla equity index to be market-cap weighted, a currency index, ideally, ought to be weighted based on some measure of trade between countries. Unfortunately, the U.S. Dollar Index falls far short of that.

The Federal Reserve has long provided data on trade and even publishes a trade-weighted U.S. Dollar Index. However, use of this index has been downplayed because of a lack of liquidity of some of the underlying currencies. But times have changed.

Take China, a large and growing U.S. trading partner. Its economy could be as big as the U.S.’ within half a decade, but there isn’t a trace of yuan in the U.S. Dollar Index. Sure, the yuan still floats less than freely, but it’s beginning to. It just seems preposterous to me that it’s excluded from the index.

This isn’t just an academic discussion. The U.S. Dollar Index’s composition affects the way that ETFs benchmarked to the index work.

I’ll get to that, but for the record, let’s take a look at the current composition of the US. Dollar Index:

Currency Weights

When we look at trade-weighted data that reflects how dollars circulate in the global economy, it’s even more alarming just how out of sync the U.S. Dollar Index is, especially in comparison with the trade-weighted U.S. Broad Dollar Index:

Trade Weighted Dollar Index Weights

It’s easy to see that the euro is overweight in the U.S. Dollar Index, but take a closer look at what else is going on.

Just as China or Mexico ought to be included because they are such important U.S. trading partners, you’ve got to wonder why a country like Sweden has a 4.2 percent weighting in the index. I get that it’s because so much of its currency trades freely outside its borders, but come on.

I also understand the consideration given to liquidity. But when valuing the dollar in the truest sense, it’s illogical to say that China should be thrown out, dirty float notwithstanding. Also, excluding the Mexican peso, now the 12th-most-traded currency in the world, the U.S. Dollar Index isn’t doing investors any good when it comes to understanding the value of the dollar on a global level.

 

 

 

Real-World Consequences

As I suggested earlier, my biggest concern is how this trickles into investments in ETFs.

There are currently two ETFs that track the U.S. Dollar Index: the PowerShares DB U.S. Dollar Index Bullish Fund (NYSEArca: UUP) and the PowerShares DB U.S. Dollar Index Bearish Fund (NYSEArca: UDN).

Launched in 2007, the funds have been very successful, despite the fact they track an index based solely on liquidity. I decided to take a quick look at how UUP has performed so far this year against the two versions of the dollar index, especially given Europe’s sovereign debt crisis.

 

Dollar Index Performance

 

 

 

 

 

 

 

 

Data reported by Bloomberg as of 7/6/2011

 

As expected, UUP and the U.S. Dollar Index still underperform compared with the trade-weighted dollar index. This is no surprise, as the EUR/USD spot rate is up over 8 percent year-to-date, reflecting the euro’s appreciation.

Because UUP invests in futures on the dollar index, its performance becomes victim of the euro’s rise. I’m sorry to say for dollar bulls out there that a fund that tracked something closer to a trade-weighted index might have served you better so far this year, as the trade-weighted dollar index is down 3.8 percent compared with the 5.01 percent decline of the regular dollar index. The result? After management fees, UUP is down 5.72 percent year-to-date.

Dollar bears that invested in UDN experienced the opposite. By essentially being long the euro by almost 60 percent in UDN, dollar bears still outperform the trade-weighted index.

Bear Dollar Index Performance

 

 

 

 

 

 

 

 

 

 

So what’s the takeaway? It’s time a better product emerges that tracks the true value of the dollar. Diversifying away from the dollar has been a major concern among investors recently, but that shouldn’t mean going long the euro. The same is true for the reverse: Going long the dollar should not mean shorting the euro.

Because the regular dollar index is so heavily weighted in the euro, any products based on it are essentially plays on the euro. UUP and the Rydex CurrencyShares Euro Trust ETF (NYSEArca: FXE) are prime examples of this relationship.

A year-to-date historical regression of UUP and FXE using Bloomberg data demonstrates the relationship even further. As expected, the two funds have a strong negative correlation with an r-squared of 0.94. No surprise. The positive moves in FXE are directly related to negative moves in UUP, and vice versa.

It’s the same case with UDN, as it has a strong positive correlation to FXE, also with an r-squared of 0.94. It truly begs the question of whether investors are better off just investing in something like FXE with its expense ratio of 0.50 percent versus UDN’s 0.75 percent.

Yet, the issue still remains: Investors need better products that properly reflect the true value of the dollar. Here’s to hoping that the market answers the call.

 

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