The Buck Starts Here With These Currency ETFs

Photographer: Andrew Harrer/Bloomberg

The U.S. dollar, according to bond expert Jeffrey Gundlach, is “the place to be.”

The dollar has been strengthening as the Federal Reserve's asset-purchase program winds down. At the same time, developed markets in the Euro Zone and Japan are cranking up their own economic stimulus efforts. All of this has the Deutsche Bank U.S. Dollar Index up 9 percent this year, after five straight years of negative returns -- and DoubleLine's Gundlach thinks the dollar will go on to top its 2009 highs.

Any investor with money in the S&P 500 Index already has exposure to the dollar. But a number of exchange-traded funds offer ways to make a more concentrated bet on a stronger greenback.

Currency ETFs

While there are 39 currency ETFs, only two attempt to benefit from a strong dollar. The PowerShares DB US Dollar Bullish Fund (UUP ) is the oldest and most popular, with $963 million in assets. It makes its dollar play by betting against a basket of developed-market currencies. Its biggest bet is against the euro, with a 57 percent weight; the next biggest bets are against the Japanese yen (13 percent) and the British pound (11 percent). UUP is up 9 percent so far this year, and charges 0.80 percent of assets annually.

The new kid on the block, launched less than a year ago, is the WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU ). It shorts a basket of global currencies but is more evenly distributed among countries, with the euro a 30 percent weight. USDU also has an 18 percent exposure to emerging-markets currencies such as the Chinese yuan and the Mexican peso. It's up 6 percent year-to-date and charges 0.50 percent. Developed-market currencies are doing worse against the dollar than those of emerging markets, thanks to government stimulus programs and weak economies. That's why rival fund UUP is the better performer this year.

Currency ETFs are a tiny blip on the ETF map, with only $3.6 billion in assets out of the $1.9 trillion total in ETFs. But they offer a legitimate diversification benefit -- they tend to zig when other parts of your portfolio zag. And while investing in ETFs that use derivatives -- as these two do by shorting futures contracts -- calls for caution, the ETFs are both only a third as volatile as U.S. stocks.

Currency-Hedged Equity ETFs

Investors can also find currency-hedged equity ETFs. These can be helpful when the dollar is strong relative to other currencies. That's because a portfolio's international allocation can get out of whack when all of its foreign stock market gains get converted back into dollars, and fewer of them.

This currency conversion can be a boost or a drag. This year it has been a total drag. In Europe, for example, the currency effect is costing U.S. investors 9 percent of return. Look at the WisdomTree European Hedged Equity ETF (HEDJ ). It tracks Euro Zone stocks and hedges out the effect of the euro. HEDJ is up 3 percent this year. Compare that with the 8 percent loss of the iShares MSCI EMU ETF (EZU ), which tracks the Euro Zone but doesn’t hedge out the euro. HEDJ charges 0.58 percent annually; EZU 0.48 percent.

The dramatic performance difference is why HEDJ has had inflows of $2.5 billion this year, more than all other European-region ETFs combined. However, if the dollar starts to slide against the euro, HEDJ will underperform EZU.

There are some areas where a currency hedge makes little sense. Hedging emerging-market currencies can be expensive, for example, because the cost of the hedge is based on the interest rate in the country. In developed markets, interest rates are nearly zero, so there's virtually no cost to hedge the currency. Rates are much higher in emerging markets, and hedging them can be a 3 percent to 4 percent annual drag on returns.

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Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here; weekly ETF podcasts can be found here.

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