Should You Bet against the Dollar?
>> Oct 22, 2009
The declining value of the U.S. dollar has been making financial headlines lately. After hitting an all-time low in April 2008, the dollar rallied strongly in last fall's financial crisis as investors sought safe havens, but it has once again fallen as the world economy has recovered. As of Oct. 19, 2009, the IntercontinentalExchange Dollar Index has fallen about 15% from the high it reached in early March.
The causes behind the weak dollar are many and complex, but essentially this means that investors around the world have become less confident in the future stability of the dollar and more confident in other currencies. The effects of the weakening dollar can also be complicated, but the upshot is that it's cheaper for people in other countries to buy American-made goods and services and more expensive for Americans to buy things sold in other currencies.
The Explosion of Currency Funds
Another effect has been the creation of a slew of new mutual funds and exchange-traded funds that allow people to bet on the rise or fall of various currencies, especially the dollar. Just five years ago, there was only one such fund, Franklin Templeton Hard Currency (NASDAQ:ICPHX - News). It invests in money market bonds denominated in various foreign currencies that the managers believe are undervalued relative to the dollar, so that it benefits when those currencies rise and the dollar falls. Since the beginning of 2005, several more such funds have sprung up. There's ProFunds Rising U.S. Dollar (NASDAQ:RDPIX - News), which tracks the New York Board of Trade's U.S. Dollar Index (USDX), and ProFunds Falling U.S. Dollar (NASDAQ:FDPIX - News), which shorts the same index and thus benefits when the dollar falls. There are also leveraged dollar funds that provide twice the returns of the USDX or its inverse--Rydex Strengthening Dollar 2x Strategy (NASDAQ:RYSDX - News), Rydex Weakening Dollar 2x Strategy (NASDAQ:RYWDX - News), and Direxion Monthly Dollar Bull 2x (NASDAQ:DXDBX - News) and Monthly Dollar Bear 2x (NASDAQ:DXDDX - News).
Another effect has been the creation of a slew of new mutual funds and exchange-traded funds that allow people to bet on the rise or fall of various currencies, especially the dollar. Just five years ago, there was only one such fund, Franklin Templeton Hard Currency (NASDAQ:ICPHX - News). It invests in money market bonds denominated in various foreign currencies that the managers believe are undervalued relative to the dollar, so that it benefits when those currencies rise and the dollar falls. Since the beginning of 2005, several more such funds have sprung up. There's ProFunds Rising U.S. Dollar (NASDAQ:RDPIX - News), which tracks the New York Board of Trade's U.S. Dollar Index (USDX), and ProFunds Falling U.S. Dollar (NASDAQ:FDPIX - News), which shorts the same index and thus benefits when the dollar falls. There are also leveraged dollar funds that provide twice the returns of the USDX or its inverse--Rydex Strengthening Dollar 2x Strategy (NASDAQ:RYSDX - News), Rydex Weakening Dollar 2x Strategy (NASDAQ:RYWDX - News), and Direxion Monthly Dollar Bull 2x (NASDAQ:DXDBX - News) and Monthly Dollar Bear 2x (NASDAQ:DXDDX - News).
In the trend-chasing ETF world, Rydex has also come out with CurrencyShares, a series of exchange-traded funds that track nine different overseas currencies versus the dollar. They are CurrencyShares Australian Dollar Trust (NYSEArca:FXA.TO - News), British Pound Sterling Trust (NYSEArca:FXB - News), Canadian Dollar Trust (NYSEArca:FXC - News), Euro Trust (NYSEArca:FXE - News), Japanese Yen Trust (NYSEArca:FXY - News), Mexican Peso Trust (NYSEArca:FXM - News), Russian Ruble Trust (NYSEArca:XRU - News), Swedish Krona Trust (NYSEArca:FXS - News), and Swiss Franc Trust (NYSEArca:FXF - News). WisdomTree has a similar line of ETFs that track the Brazilian real (NYSEArca:BZF - News), the Chinese yuan (NYSEArca:CYB.TO - News), the euro (NYSEArca:EU - News), the Indian rupee (NYSEArca:ICN - News), the Japanese yen (NYSEArca:JYF - News), the New Zealand dollar (NYSEArca:BNZ - News), the South African rand (NYSEArca:SZR - News), and a basket of emerging currencies (NYSEArca:CEW.TO - News). There's also a closed-end fund, Global Income & Currency (NYSE:GCF - News), which consists of a portfolio of currencies in which the manager can either have long positions (where the fund benefits if the currency strengthens) or short positions (where the fund benefits if the currency weakens).
Given the dollar's recent weakness, it's not surprising that some of these funds have posted solid returns lately. The leveraged funds betting on a dollar decline have done especially well; Direxion Monthly Dollar Bear 2x has gained 16% so far in 2009 (as of Oct. 19), and Rydex Weakening Dollar 2x Strategy has gained 15%. Among the currency-specific funds, CurrencyShares Australian Dollar Trust has gained 33%, Canadian Dollar Trust has gained 17%, and British Pound Sterling Trust and Swedish Krona Trust have both gained around 12%. Most funds betting on the decline of the dollar have also shown double-digit gains.
Are Currency Funds Worth Owning?
You might look at such returns and be tempted to think that these funds would make good investments. But that kind of thinking is potentially dangerous, because it assumes that recent results will continue indefinitely. (They never do.) Chasing performance is usually a bad idea in any case, but currency movements are especially volatile and highly unpredictable, often defying macroeconomic factors and the predictions of experts. It's possible that you could get good short-term returns if you bought a falling-dollar fund right now, but you could easily get burned.
You might look at such returns and be tempted to think that these funds would make good investments. But that kind of thinking is potentially dangerous, because it assumes that recent results will continue indefinitely. (They never do.) Chasing performance is usually a bad idea in any case, but currency movements are especially volatile and highly unpredictable, often defying macroeconomic factors and the predictions of experts. It's possible that you could get good short-term returns if you bought a falling-dollar fund right now, but you could easily get burned.
Just look at what happened to the ProFunds dollar funds when they first came out in early 2005. ProFunds Falling U.S. Dollar gathered considerably more assets than Rising U.S. Dollar right out of the gate, because the dollar had fallen precipitously in 2004 and most people expected it to remain weak. (See this article about currency effects from the end of 2004.) But the dollar rallied strongly in 2005, so that Falling U.S. Dollar lost nearly 10% by the end of the year, and Rising U.S. Dollar gained 12%. Since then, both funds have been on a roller-coaster ride: the dollar fell in 2006 and 2007, rose again in 2008, and has fallen again this year, and the funds have fluctuated accordingly.
It's not a good idea for individual investors to make big bets on the direction of the dollar, as that's really a form of speculation. But that's not to say foreign currency exposure is a bad idea. Indeed, it can be a good way to diversify a portfolio and hedge against the possibility of a further fall in the dollar. However, currency funds aren't necessarily the best way to get such exposure. For one thing, many of them are expensive. The CurrencyShares ETFs only cost 0.40%, and Franklin Templeton Hard Currency isn't too bad, at 1.09% for A shares and 0.78% for Advisor shares. But the ProFunds, Rydex, and Direxion funds are all pretty pricey, as such funds tend to be; ProFunds Rising U.S. Dollar is the cheapest of the bunch, with a 1.58% expense ratio for Investor shares.
Other Options for Currency Exposure
For the great majority of investors, there are better ways to get foreign-currency exposure, such as through foreign-stock funds, as long as they're unhedged. Managers of unhedged funds don't try to offset the effect of fluctuations in the dollar, so when the dollar falls, these funds benefit, and vice versa. Even some domestic-stock funds can benefit from dollar weakness if they hold a lot of multinational firms that get a large chunk of their revenues abroad, such as Coca-Cola (NYSE:KO - News) or McDonald's (NYSE:MCD - News). True, these funds offer a less-direct route to foreign-currency exposure, but if you have substantial exposure to international stocks--especially small caps, which tend to be more dependent on movements in local currencies--it's probably enough. (As Morningstar's Gregg Wolper recently noted, some funds have recently stopped hedging their currency exposure into the dollar, but others have started doing so.)
For the great majority of investors, there are better ways to get foreign-currency exposure, such as through foreign-stock funds, as long as they're unhedged. Managers of unhedged funds don't try to offset the effect of fluctuations in the dollar, so when the dollar falls, these funds benefit, and vice versa. Even some domestic-stock funds can benefit from dollar weakness if they hold a lot of multinational firms that get a large chunk of their revenues abroad, such as Coca-Cola (NYSE:KO - News) or McDonald's (NYSE:MCD - News). True, these funds offer a less-direct route to foreign-currency exposure, but if you have substantial exposure to international stocks--especially small caps, which tend to be more dependent on movements in local currencies--it's probably enough. (As Morningstar's Gregg Wolper recently noted, some funds have recently stopped hedging their currency exposure into the dollar, but others have started doing so.)
You can rev up your portfolio even further with an unhedged foreign bond fund. Currency price fluctuations account for a larger share of these funds' returns, and because the dollar has been in the doldrums, they've been among the best-performing fixed-income funds. But keep in mind that foreign bond funds can be very volatile; emerging-markets bond funds got creamed in 2008 before rallying strongly this year. Investors should tread cautiously, if at all, before delving into such funds. (Morningstar.com Premium Members can find a list of our favorite world-bond funds here and our favorite emerging-markets bond funds here.)
This article by Arijit Dutta discusses in more detail how investors can broaden their currency exposure, and this one by Gregg Wolper discusses the various currency-hedging strategies that funds use. None of this means that you absolutely need to avoid currency funds at all costs--but if you do consider investing in one, make sure you know how to use it, and keep your expectations reasonable.
David Kathman, CFA does not own shares in any of the securities mentioned above.
