ETFs For The Dollar Bull

The Street seems to be clamoring for long-dollar plays. Maybe you’re already covered.

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Reviewed by: Dave Nadig
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Edited by: Dave Nadig

The Street seems to be clamoring for long-dollar plays. Maybe you’re already covered.

The headlines this weekend were full of hand-wringing about the dollar. The dollar’s stronger, so we’re all doomed. The dollar will crash, so were all doomed. You can pretty much pick any side of a currency argument, and there will be someone telling you it’s a sign of the end-times.

But the reality for most investor portfolios is actually nuanced, and if my inbox is any indication, pretty widely misunderstood.

Let's get back to basics and consider what currency really means in your portfolio.

You’re In A Dollar World

Most American investors are already extremely long the dollar. We get paid in dollars. Our biggest assets—our houses, our cars—are already denominated in dollars. If you’re like most investors, your home bias in your portfolio is extreme, and something like 80 percent of your financial assets are also in dollars—U.S. stocks, dollar-denominated bonds.

Honestly, that’s not necessarily terrible. After all, if you put your pension-fund-manager hat on, most of your liabilities are also denominated in dollars. You have to pay your mortgage and your grocery bill in dollars. You’ll likely send your kids to a U.S. college, and your hospital will charge you in dollars if you get sick.

Why then should you be concerned about the dollar? Because we live in a global economy.

While it’s true your mortgage may be in dollars, when you go to buy a new car, a lot of the parts have come from outside the country. Imagine you’re buying a widget for your car that cost a dollar today, and was shipped from Brazil. If the real collapses and the dollar soars 100 percent relative to the real, well, in order to get the same widget, you now only have to pay 50 cents. Your dollar is 100 percent more valuable.

But it goes both ways. Say your company makes video games. You want to sell your video game to gamers in Brazil. Well, today your video game—which you’d like to get $60 for—costs that Brazilian gamer about 140 teal. If the dollar soars against the real, that game’s going to cost him 280 reals.

Unless that Brazilian gamer got a rather monumental raise in local currency terms, you’re probably out of luck, and your company just won’t make those sales to Brazil.

A Tisket A Basket

The most common way to look at “how’s the dollar doing” is to look at the US Dollar Index. It’s a measure of the dollar versus the six big currencies: the euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc.

In reality, the euro dominates, with nearly 60 percent of the basket, with less than 10 percent weights to the yen and pound as well. It’s not an entirely irrational basket, but it probably downplays the importance of Asian currencies. Still, it’s the standard. And the value of the dollar does fluctuate against this basket over time … a lot:

 

USDX

 

There’s a bit of a myth that currency is a languid market. While it’s true the intraday volatility of, say, the dollar/yen cross isn’t high, over business cycles the value of the dollar can skyrocket and plummet. Look at what happened coming out of the energy crisis in the 1970s, or the meteoric rise during the dot-com boom.

While currency is impacted by a lot of global economic issues, the No. 1 driver—decade in and decade out—is interest rates. Consider the same chart with the yield of the 10-year U.S. Treasury overlaid:

USDX_INTEREST

It’s by no means a perfect match, but in general, when interest rates are high in the U.S., the dollar is strong.

If you think about it from the perspective of an international investor, it makes sense. If the U.S. government is paying 10 percent on 10-year Treasurys, investors from around the world will flock to U.S. Treasurys, and they’ll have to buy a lot of dollars to do that. To buy dollars, they have to sell their local currency. The local currency goes down, the dollar goes up.

Currency investing can be seen as this enormous cat-and-mouse game of interest rates and investment opportunities. And that’s why everyone—or nearly everyone—is saying the dollar will be stronger for some time to come. Because pretty much everyone thinks the Fed will start raising interest rates, making the dollar ever more attractive.

The Dollar And Your Portfolio

So what does this mean for you as a U.S. investor? Every investment you make has a currency component. Even if you never invested a penny outside the U.S., that would mean, whether you like it or not, you are betting on a strong dollar.

If, on the other hand, you take a big chunk of your portfolio and invest it overseas, say in the iShares MSCI EMU ETF (EZU | A-61), which invests in the biggest companies in the European monetary union, you’re explicitly selling your dollars to go long the euro, on top of your call to invest in the fortunes of Anheuser-Busch and Siemens.

Every international investment is also a currency investment. Even hard-asset plays are currency plays. Consider the relationship between the dollar and gold:

 

USDX_GOLD

Again, not a perfect correlation, but the decision to go long gold is the decision, essentially, to trade your dollars for this physical lump of metal that doesn’t pay a dividend and doesn’t magically make more of itself.

That shiny lump, if you then sell it to get dollars back, is a pure bet on the value of the dollar. If the purchasing power of the dollar goes down, well, when you sell your gold, you will get more dollars. If the purchasing power of the dollar goes up, you’ll get fewer dollars when you sell.

It’s not all that different than betting on the euro, except there’s no central banker to mess up your nice shiny lump of gold.

ETFs For The Dollar?

As an ETF investor, you’ve got an extremely sharp toolbox to manipulate your dollar exposure. If you believe the dollar will in fact soar, you can just double-down on your dollar exposure with an ETF like the PowerShares DB US Dollar Index Bull ETF (UUP | D-73), or the WisdomTree Bloomberg US Dollar Bullish Index (USDU | 67).

UUP shorts the U.S. Dollar Index currencies (making you even longer the dollar than you are sitting in cash), while USDU shorts a basket more closely related to the balance of trade between the U.S. and the world (so it’s only short the euro 31 percent, and includes other currencies like the Korean won and Australian dollar).

 

CURRENCYETFS

Neither ETF is necessarily better—the big difference is, and will continue to be, how the euro fares. UUP is a big, big bet on a declining euro, while USDU is more diversified. You need to have an opinion before pulling the trigger on either.

[NOTE: I forgot in my original post that USDU has one additional thing going for it—no K1 partnership form at the end of the year. That can save you some hassle at tax time, and if you hold for longer than a year, it puts you in regular old long-term capital gain territory.]

Not Long & Hold

But let’s be clear—these are speculative currency bets, not long-term asset class investments. And those longer-term allocations are where more investors are probably making accidental currency bets than anywhere else.

Back in 2013 was the first time many investors even heard about the idea of currency-hedging their international exposure. That’s because in 2013 the local Japanese stock market was up 26 percent, while the hedged version—the version in the Deutsche X-trackers MSCI Japan Hedged ETF (DBJP | B-72) was up more than 50 percent. Those kinds of returns get people to pay attention, and nobody likes leaving 25 percent on the table just because they didn’t think about their currency exposure.There are now currency-hedged international equity ETFs from iShares, Deutsche, WisdomTree and I’m sure soon to be others, covering most developed and major emerging markets.

In other words, you don’t have any excuses, and you have to have an opinion. Every investment is a currency investment, whether that’s local or international.

If you throw your hands up in the air and say, “I don’t know!” well, you just went long the dollar for your U.S. exposure, and short the dollar for your international exposure. You vote with yourinvestments whether you want to or not. At the very least, take a hard look at your portfolio and know which way you voted.


At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.


Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.