By
Morningstar
:
By Michael Rawson, CFA
Prospects for the U.S. dollar have weakened substantially in
light of large budget and trade deficits compounded by the Fed's
response to the financial crisis. The current quantitative easing
programs employed by the Federal Reserve are tantamount to printing
currency, which could further weaken the U.S. dollar. Over the past
decade, the U.S. dollar has already declined by about 20% compared
to a trade-weighted, broad basket of currencies. In response,
investors have increasingly looked to foreign currencies. Let's
review the pros and cons of adding currency investments to your
portfolio through an analysis of Powershares DB US Dollar Index
Bearish (
UDN
).
UDN tracks the performance of a basket of currencies against the
U.S. dollar. It is important to remember that currencies are not a
productive asset (unlike a factory), thus they offer very little
return potential over the long run. For those betting on a general
U.S. dollar depreciation, this fund provides a better tool than
single-currency funds because it tracks the performance of six
foreign currencies, namely the euro, Japanese yen, British pound,
Canadian dollar, Swedish krona, and Swiss franc, against the U.S.
dollar. It does not include the currencies of faster-growing
emerging markets and is heavily weighted toward the euro.
Currency funds are generally poor long-term investments because
there is no positive expected return beyond the risk-free rate,
which barely keeps up with inflation. Currencies are a zero-sum
game in that all currencies cannot rise in value together. Despite
higher volatility, the long-term expected return in stocks is
positive. But with currencies, interest-rate parity suggests that
the expected excess return is zero.
Those hoping to speculate on short-term movements in the dollar
should be wary. Predicting short-term movements in currencies
remains a nearly impossible task that has flummoxed academics and
traders for decades. While the dollar looks ripe for long-term
depreciation relative to the other currencies because of the
declining prominence of the U.S. economy and reduced benefits to
the dollar from its use as a reserve currency, that trend will
likely play out over a decade or more without producing sufficient
return to justify the tied-up capital. Because of these
considerations, we feel the typical investor has little reason to
hold anything more than a small position in this fund. For more
information on the appropriateness of currency investing,
see this article
by Morningstar's John Gabriel.
Despite the above warnings, a foreign-currency fund has its
legitimate uses as either a short-term, low-risk holding or as a
cheap hedging instrument. Currencies can be thought of as a
short-term IOU issued by a government. They tend to have low
volatility but low returns. In a world of lower returns on capital
and increased volatility, a currency could have a legitimate place
as part of a diversified portfolio. Additionally, anyone
anticipating a large foreign currency expense could hedge the risk
that those currencies will appreciate by investing in this
exchange-traded fund and locking in the dollar cost today. If the
dollar declines, the losses the hedge faces on his dollar holdings
will be offset by gains in this fund. Those who are exposed to U.S.
stocks and worry that those stocks could be negatively impacted by
a decline in the dollar could hedge that currency risk by investing
in this fund. Currencies have a reputation for being volatile, but
that's because leverage is often used to amplify the returns. Over
the past five years, the S&P 500 has gained 1.1% on an
annualized basis with volatility of 19%, while the BarCap U.S.
Aggregate Bond Index has gained 6.9% with volatility of just 3.6%.
By comparison, UDN has gained 0.4% with volatility of 10%. The
correlation to the S&P 500 over that time was 0.63. So the risk
of UDN has been somewhere between stocks and bonds with some
potential for diversification.
Fundamental View
In the long term, two major factors tend to drive currency
movements: the relative growth of monetary bases (the number of
dollars or foreign currency in the economy) and the relative growth
of the underlying economies using those currencies. The mature
foreign economies represented in this fund are unlikely to grow at
vastly faster rates than the United States such that those
currencies significantly appreciate.
While in the past 10 years the U.S. dollar has lost about 20%
against a broad basket of currencies, it is still looked to as a
safe-haven currency. We think the long-term trend toward a weaker
dollar will remain, as the U.S. faces twin current account and
budget deficits. One path to improving U.S. financial health is
through exports, which would benefit from a weaker dollar. While
current stimulative monetary and fiscal policies in the U.S. may
weaken the dollar, it would require drastic differences in policy
to devalue the currency so much that this fund would provide a
solid return.
Because this fund is about 57% invested in the euro, investors
trying to diversify away from U.S. market risk should realize that
both the U.S. and Europe face similar economic problems in terms of
slowing economic growth and fiscal deficits. In addition, the
European sovereign-debt crisis has called into question the
sustainability of the euro common currency. In response, euro-area
member states have launched a number of programs in an attempt to
restore confidence in weaker countries, including Portugal,
Ireland, Italy, and Greece. These programs have included bond
buying and Long-Term Repo Operations by the European Central Bank
and the establishment of the European Financial Stability Facility
to provide funds for distressed countries. As these countries
struggle with imposed austerity measures, GDP is widely expected to
contract in 2012. The need for further government intervention will
be a source of volatility and political instability. Recent talk of
Greece exiting the euro only adds to questions surrounding the
currency. Investors with a bearish view of current U.S. monetary
policy would be better off investing in gold, commodities, or
foreign stocks.
Portfolio Construction
Rather than holding currencies directly in a bank account, the fund
tracks an index of currencies futures designed to replicate the
performance of six foreign currencies--the euro, Japanese yen,
British pound, Canadian dollar, Swedish krona, and Swiss
franc--against the U.S. dollar. The euro is weighted at 57% of the
fund, while the yen is the second-largest weighting at 14%. These
weightings are fixed and were originally proportional to trade
flows between the original G-10. Unlike commodity futures, which
face limited arbitrage because of issues such as storage costs,
contango roll risk is not a substantial risk for liquid,
developed-markets currencies. Investors should note that UDN is
structured as a limited partnership. Rather than receiving a
summary Form 1099 at the end of the year, investors will receive a
Schedule K-1 to report their portion of the company's earnings.
Even if investors do not sell their shares or receive a
distribution, they may have to report an amount that is taxed as
ordinary income. Capital gains are taxed at a 60%/40%
long-term/short-term blended rate.
Fees
PowerShares DB US Dollar Index Bearish Fund charges up to a 0.75%
fee. This is high by ETF standards and higher than the fee on other
currency ETFs.
Alternatives
Because 57% of this fund is a bet on the euro, investors might want
to consider buying CurrencyShares Euro Trust (
FXE
), which charges a lower fee of 0.40% and invests cash directly in
euro-denominated bank accounts rather than using futures. Both
iPath EUR/USD Exchange Rate ETN (
ERO
) and WisdomTree Euro Debt (
EU
) offer exposure to the euro but are thinly traded relative to FXE.
CurrencyShares also offers single-currency ETFs that track the
Canadian dollar, Japanese yen, Swiss franc, Swedish krona, and
British pound.
WisdomTree Dreyfus Emerging Currency (
CEW
) gains currency exposure by holding short-term bonds in currencies
of several emerging-markets countries at an expense ratio of 0.55%.
WisdomTree Emerging Markets Local Debt (ELD) holds emerging-markets
bonds, so it should have a higher yield while still gaining
exposure to emerging-markets currencies.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
Any Market Surprises Coming At The End Of Quarter
Three?
on seekingalpha.com