Betting On A Rising Dollar With ETFs

After two years of stellar gains, it's an open question whether the rally in the U.S. dollar will continue in 2016. There are another 250 or so trading sessions to go before the final verdict is in, but if the first few days of January are any indication, it's looking like another good year for the greenback could be in the cards.

So far in 2016, the U.S. Dollar Index is up a little less than 1% after having jumped 12.8% in 2014 and 9.3% in 2015. If the dollar is about to embark on another run this year, perhaps now is the time to go long, especially as other asset classes such as stocks struggle.

U.S. Dollar Index

The Bullish Case For The Dollar

By now, the bullish case for the dollar is pretty well known to most investors, and stems from the divergence in monetary policy between the U.S. Federal Reserve and other central banks. At the same time that the Fed is hiking rates, other central banks are either holding steady or loosening policy.

Two central banks in particular—the European Central Bank and the Bank of Japan—are experimenting with enormous quantitative easing programs, putting pressure on their respective currencies, the euro and the yen.

Yet as well as the dollar has done against those developed-market rivals, it has performed even more phenomenally against emerging market currencies.

Rapidly decelerating growth in emerging economies has prompted capital to flee former investor darlings such as Brazil, Russia and China. In turn, these countries' currencies have been plunging against the dollar.

The dollar gained 49% against the Brazilian real last year; gained 19.4% against the Russian ruble; and gained 4.6% against the Chinese yuan.

Dollar Surges Against Emerging Market Currencies

Indeed, the Chinese government has recently showed a willingness to let the country's currency depreciate significantly in recent weeks, with the yuan-dollar exchange rate touching its lowest level in five years yesterday.

If China continues to slow, more losses could be in store for the yuan, and conversely, more gains for the dollar.

Broad Dollar Exposure

Assuming the dollar continues to ascend, there are a number of ways investors can profit using exchange-traded funds.

The largest and most liquid long-dollar fund out there is the PowerShares DB US Dollar Index Bullish ETF (UUP | B-73), which goes long the greenback against rivals such as the euro, yen, pound and a few others. UUP has a relatively hefty 0.74% expense ratio, but even so, managed to return 7% last year.

A competing product is the cheaper WisdomTree Bloomberg US Dollar Bullish ETF (USDU), with a 0.50% expense ratio. USDU goes long the dollar against a basket of currencies that's broader than that of UUP and includes the Chinese yuan and Mexican peso. The lower expense ratio and broader approach helped the fund outperform in 2015, with a return of 7.6%.

2015 Returns For UUP, USDU

UUP and USDU are the only ETFs that provide long exposure to the dollar against a basket of currencies.

Leveraged Funds

Another popular fund is the UltraShort Euro ETF (EUO), which provides 2x leveraged short exposure on the euro relative to the dollar. EUO is the second-most-popular currency ETF, with more than $525 million in assets. Even with its chunky 0.93% expense ratio, the fund delivered an 18.1% return last year.

The UltraShort Yen ETF (YCS) also provides leveraged short exposure, but to the Japanese yen. It didn't fare as well in 2015, with its 1.6% loss, but it did extremely well in 2014, with a 26% gain. If John Mauldin is right about the dollar potentially climbing to 200 against the yen in the future, YCS could be a big winner.

Unfortunately, there are no ETFs that go long the U.S. dollar against emerging market currencies. There are a host of funds that take the opposite approach—going short the dollar against emerging market currencies, but that's obviously a strategy that has done abysmally recently.

For example, the WisdomTree Brazilian Real ETF (BZF | C-91) tanked 25.6% last year, while the WisdomTree Emerging Currency ETF (CEW | C-45) lost 9.6%.

Daring investors could opt to short those ETFs, which would effectively be like going long the dollar against those respective currencies.

2015 Returns For EUO, UCS, BZF, CEW

Currency Hedging

ETFs like those mentioned above are the simplest, most straightforward vehicles to go long the dollar. But there are other ways to make a bet on the dollar indirectly.

Currency-hedged ETFs, such as one of 2015's most popular fund, the WisdomTree Europe Hedged Equity ETF (HEDJ | B-49), give investors the ability to pair their long exposure on a certain segment of the market with a currency bet.

In the case of HEDJ, investors receive exposure to eurozone stocks and short euro (long dollar) exposure. The short-euro position offsets the inherent long-euro exposure of owning eurozone stocks; hence why these are called "currency hedged" ETFs.

For U.S. investors betting on a rising buck, currency-hedged ETFs are the superior option compared with their plain-vanilla counterparts. However, they are far from pure-play bets on the currency market and should not be treated as such.

Contact Sumit Roy at [email protected].