More investors make the wrong play in currencies than perhaps anywhere else in the market.
That’s because currencies are confusing.
Even interpreting headlines to account for currencies can be confusing. Debt crisis in the U.S. means a weak dollar? Eurozone finances mean a weak euro?
But understanding the implications is important, because no matter what you do, you’re making a play on currency.
By default, most U.S. investors start long the dollar. It’s the base scenario. You get paid in dollars. Your dollars sit in a bank account. Your dollars earn some rate of U.S.-dollar-denominated interest. Even keeping greenbacks in a mattress is an inherent bet on the dollar.
As soon as you make an investment, however, you’re making a bet relative to the value of the dollar, whatever it is you’re buying. If you’re a real estate prospector and buy a piece of land in upstate New York, you’re counting on that land appreciating in value versus the dollar.
That’s just another way of saying you’re hoping its price increases. However, because both the land and your bank account are valued in U.S. dollars, there’s no external force that will break the two apart in value other than supply and demand for real estate. They both have this “long dollar” component. You’re just hoping that in 10 years, the value of the land will be more than the value of those same dollars kept in cash.
If you buy an international equity fund, however, you’re betting on two things at once—that the companies in the fund grow, just like the value of that piece of land in New York; and that the currency in which they’re priced goes up relative to the dollar.
Let’s say you buy a share of Bob’s Fish & Chips that costs 10 pounds, at today’s exchange rate of 0.627 pounds to the dollar. You pay $16.08 for you shares. You can make money if the price rises to 11 pounds, increasing the dollar value of your position to $17.69.
But you also make money if the exchange rate tips in your favor, the dollar weakens and Bob’s Fish & Chips stays at 10 pounds. If the dollar fell to the point where it only bought 0.5 of a pound instead of 0.627, you’d have $20 worth of Bob’s, even with the actual price of the shares unchanged.
Getting Tripped Up
In a very real way, every investment embeds either a long- or short-dollar component, and this is what trips up investors.
Consider for a moment that you want to short the U.S. dollar. It means to trade your dollars in for something else. In the world of currencies, this means buying a fund that simply holds a foreign currency. It could also mean holding very-short-term bonds in that currency, just like you’d put your spare cash in a money market fund to stay if you planned on staying in dollars.
That’s what products from Rydex CurrencyShares such as (NYSEArca: FXE) for the euro, (NYSEArca: FXY) for the Japanese yen or (NYSEArca: FXB) for the British pound. The other alternative is to simply buy a basket of currencies, which is what the PowerShares US Dollar Index Bearish ETF (NYSEArca: UDN) does, through futures contracts.
People get confused, however, because of the names of the funds. UDN, for example, sounds like an inverse fund, when in fact it’s the equivalent of buying six different “long” currency ETFs—euro, pound, yen, Canadian dollars, Swedish krona and the Swiss franc.
As the chart shows, over the past two years, while the euro’s been flat, UDN has managed to eke out returns of just over 5 percent.
I added the WisdomTree Dreyfus Emerging Currency Income Fund (NYSEArca: CEW) to show that the basket strategy can be applied to more than just the big six to even more exotic currencies in emerging markets. It’s an idea that’s been a great play, as both the euro and dollar have had their issues.