A Long-Dollar ETF For The 21st Century

WisdomTree’s long-dollar currency ETF is the right fund at the right time.

WisdomTree’s new long-dollar currency ETF is truly one for the ages, literally. I’ve long felt that we’ve needed an alternative to the decades-old US Dollar Index, which was created back in 1973.

So how does the WisdomTree Bloomberg US Dollar Bullish Fund (USDU) differ from its lone competitor, the $682 million PowerShares BD US Dollar Bullish Fund (UUP | B-39), which also happens to be the largest currency ETF?

For starters, there are major differences in the composition of the two funds. There are also differences in the structure of the ETFs.

More on that later, but first let’s start with the currency basket.

WisdomTree’s USDU closely follows the newly created Bloomberg Dollar Spot Index (BBDXY), which includes a trade- and liquidity-selected and -weighted basket of currencies that is rebalanced annually in December.

USDU currently shorts a basket of 10 currencies from major U.S. trading partners from developed as well as emerging markets, including the Brazilian real, Mexican peso, South Korean won and Chinese renminbi.

While USDU is technically an active fund, this has more to do with regulatory factors surrounding listing requirements for currency funds, rather than because the fund is an active strategy where the manager freely picks currencies based on macroeconomic analysis.

In fact, USDU attempts to track BBDXY as closely as possible using forward currency contracts. That said, USDU does attempt to beat the “Total Return” version of the index, which naturally underperforms the “Spot Index” due to negative carry costs associated with shorting high-yielding currencies (remember that the index is “short” the currency basket relative to the dollar).

In comparison, UUP’s underlying index, the US Dollar Index (USDX), was created and weighted according to global trade in the early 1970s. It dates back to the collapse of the Bretton Woods currency system when President Nixon took the dollar off the gold standard.

Since then, the composition of USDX has been fixed. It’s been “adjusted” once in 1999 with the introduction of the euro, when several European currencies were rolled into the single currency.

The euro now makes up close to 60 percent of the index’s weighting, making the index highly correlated to movements in the euro.

A quick peek at the currencies included in the two ETFs shows just how different they are in composition.

USDX Vs. BBDXY Composition

Source: Bloomberg

According to Rick Harper, director of Currency and Fixed Income at WisdomTree, BBDXY constitutes 94 percent of the daily FX volume, compared with USDX’s 80 percent. From a trade perspective, BBDXY represents more than 80 percent of trade with the U.S. versus 42 percent represented by USDX.

A few things are worth pointing out here that will play a major role in the returns of UUP and USDU going forward.

USDU clearly has less exposure to the euro. Over the past year, the euro was actually one of the few currencies that appreciated against the dollar as fears of a eurozone breakup subsided.

Many investors are now looking to short the yen or emerging and commodity currencies against the dollar just as much, or even more so, than the euro.

USDU also carries a larger weighting to the yen, which is one of the most shorted currencies of the year, as Abenomics—Prime Minister Shinzo Abe’s economic plan—aims to devalue the Japanese currency to spur exports and inflation.

Looking at commodity currencies, the Canadian dollar carries a larger weight, and the Australian dollar—one of the biggest laggards of 2013 and nowhere to be seen in the USDX—is also in USDU’s mix.

Finally, from emerging markets, we have the Mexican peso, Korean won, Chinese renminbi and Brazilian real.

The Korean won looks like a good shorting candidate, as the won has appreciated close to 30 percent against the yen since Abe’s election in late 2012. Korean authorities are now constantly monitoring the won for possible intervention to prevent further appreciation.

As for China’s renminbi, it’s probably beneficial that it’s capped at 3 percent of the fund’s weighting, because it’s doing nothing but appreciating against the dollar since the break of its peg roughly 10 years ago.

All these differences paid off in 2013, as seen in BBDXY’s outperformance relative to USDX.

Note: includes backtested data; Source: Bloomberg

Fund Structure And Taxes

The other component that’s often overlooked is fund structure and tax implications.

UUP holds USDX futures contracts, meaning it’s structured as a commodities pool. This means the fund is “marked to market” at year-end, and is classified as a limited partnership by the IRS. Investors report taxes on K-1s, as opposed to 1099s.

Gains on share sales are also taxed like futures contracts: 60 percent long-term and 40 percent short-term (a blended maximum rate of 27.84 percent). This is regardless of holding period. So, as a trader, this can be an advantage, but less so for long-term investors.

In comparison, USDU uses forward currency contracts and parks its cash collateral in ultra-short-duration Treasury Bills, meaning it’s structured as a 1940 Act open-ended fund.

USDU’s tax treatment is thus like most equity ETFs. Shares held for a year or less are taxed at short-term rates, while shares held more than a year are taxed at the beneficial long-term capital gains rates. Tax reporting is also on a 1099.

However, most of USDU's gains from its forward currency contracts are expected to be distributed to its shareholders annually, and those distributions are generally taxed at the same blended rate applicable to futures contracts (similar to UUP).

In terms of fund fees, USDU’s 50-basis-point annual expense ratio—$50 for each $10,000 invested—is a full 30 basis points less than UUP’s 80 basis points.

That said, USDU is expected to have slightly higher carry costs. WisdomTree’s Harper estimates those costs to be roughly 80 basis points in the coming year, reflecting shorting of forward contracts of higher-yielding emerging currencies, from Brazil and Mexico to commodity currencies like the Australian dollar.

USDU In 2014

There’s an increasing number of investors who think that the decade-old dollar bear market is coming to an end and are looking for ways to go long the dollar as the Fed starts its tapering program.

At the same time, investors are getting tired of the USDX and are searching for an index that’s more reflective of the current FX market and global trade.

While I’m not convinced just yet that the cheap dollars flooding the global economy are going to stop flowing, if I were to short a basket of currencies against the dollar, I would prefer USDU to UUP, hands down.

A new dollar index is long overdue, and USDU is the most promising currency ETF launch in years. Throw in a rising dollar environment, and I think USDU is going to be a force to be reckoned with.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.