ETF Winners & Losers If Dollar Rally Persists

October is shaping up to be a great month for the U.S. dollar. Month-to-date, the U.S. Dollar Index is up 3.4%, a sizable move for the world's most important currency. October's rally has pushed the buck into positive territory for the year, and to the highest level since February.

A Brexit-fueled slide in the British pound and growing expectations of a Federal Reserve rate hike in December are the two biggest drivers of the latest jump in the Dollar Index.

The dollar now finds itself near key levels that could turn out to be extremely meaningful not just for the currency itself, but for broader financial markets. Currently, the Dollar Index is trading at 98.6, less than 2% below the multiyear high of 100 set last year.

US Dollar Index

The Dollar Index ticks into the green for the year after surging 12.8% in 2014 and 9.3% in 2015.

"If it can break above that level in a meaningful fashion, it is going to be incredibly bullish for the dollar on a technical basis," wrote Matt Maley, equity strategist for Miller Tabak, in a recent research note.

Though Maley doesn't consider a Dollar Index "breakout" above 100 his base-case scenario, the fact that the index is so close to this key level means investors should at the very least be prepared for another big increase in the dollar.

Impact On Currency ETFs

In the ETF world, the most obvious impact from a dollar breakout will be on currency ETFs. The $863 million PowerShares DB US Dollar Index Bullish ETF (UUP) (which tracks the U.S. Dollar Index), and the $217 million WisdomTree Bloomberg US Dollar Bullish Fund (USDU) (which tracks the broader Bloomberg Dollar Index), both stand to benefit from gains in the greenback.

Certain ETFs tied to single-currency pairs will also benefit, such as the ProShares UltraShort Euro ETF (EUO) and the ProShares UltraShort Yen ETF (YCS), which provide 2x-leveraged exposure to the dollar against the euro and yen, respectively.

On the flip side, most of the other currency ETFs on the market provide investors with short dollar exposure and would likely get hit hard if the dollar continues to rally.

Currency-Hedged ETFs Back In Focus

A spike in the dollar will also put currency-hedged ETFs back in focus for investors. These ETFs were extremely popular in 2014 and 2015, when the dollar was surging, but fell out of favor this year, as the currency stalled.

For example, the WisdomTree Europe Hedged Equity Fund (HEDJ) was the most popular ETF of 2015, with inflows of $13.9 billion, according to FactSet. In sharp contrast, the ETF is 2016's least popular ETF, with outflows of $7.4 billion.

When the dollar is rising, vanilla funds with international exposure face pressure as their holdings―which are denominated in foreign currencies―lose value when translated back into dollars. Currency-hedged ETFs offset these losses by shorting the foreign currencies in question. In the case of HEDJ, it shorts the euro to offset the underlying long euro position of its equity holdings.

HEDJ, like other currency-hedged ETFs, tends to outperform its vanilla counterparts in a rising-dollar environment and underperform in a falling-dollar environment.

Pressure On Large-Cap Equity ETFs

Though currency-related exchange-traded funds will be the most impacted, any significant increase in the dollar will reverberate throughout financial markets.

Many U.S. companies will have to deal with a much more challenging export environment as a strong dollar makes them less competitive. Those same companies will see their overseas profits reduced when converted back into dollars.

Stocks of these multinationals tend to be concentrated in large-cap indexes such as the S&P 500 (the percentage of products and services produced or sold by S&P 500 companies outside the U.S. was 44.3% in 2015). Thus, ETFs such as the SPDR S&P 500 (SPY) could face head winds from the dollar's ascent.

In the fixed-income markets, a strong buck makes it more difficult for foreign governments and companies to service their dollar-denominated debt. In turn, ETFs such as the iShares JP Morgan USD Emerging Markets Bond ETF (EMB), which has seen a lot of interest this year, may stumble if the Dollar Index spikes well above 100.

Contact Sumit Roy at [email protected].