UDN: Turning a Weakening Dollar Into Portfolio Strength

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 |  Includes: UDN, UUP
by: Don Dion

The U.S. dollar has dropped more than 5% against the euro since the Federal Reserve began cutting interest rates last September, making it the fourth-worst performer among the 16 most active currencies through February 18. The euro recently climbed to $1.47 against the dollar, just shy of an all-time record, due largely to several new indications that the U.S. economy could be stumbling into recession.

PowerShares DB US Dollar Index Bearish Fund (NYSEARCA:UDN) benefited from the dollar’s decline, posting a return of about 1% in the week ending February 14 and holding on to its rank of eighth among all funds covered by the PowerShares Momentum Tracker. If the dollar continues to weaken, UDN should continue to outperform its PowerShares currency peers—particularly its polar opposite, PowerShares DB US Dollar Index Bullish Fund (NYSEARCA:UUP).

PowerShares launched both UDN and UUP one year ago this week. The ETFs were designed to allow investors to stake out positions on the direction of the U.S. dollar by taking on exposure to futures contracts tied to the U.S. Dollar Index. The bearish ETF thrived during the following year, as the dollar hit all-time lows against several currencies. UDN gained nearly 12% between inception and February 18, while UUP lost nearly 6%.

The U.S. Dollar Index [USDX] measures the value of the U.S. currency against a basket of six other major currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. The mechanics behind the two ETFs are somewhat complicated, but here’s a basic rundown of how the funds work: Each fund invests in futures contracts of a version of the Deutsche Bank U.S. Dollar Index. UDN effectively short-sells the dollar versus the rest of the index, while UUP invests long in the dollar. The futures contracts these funds invest in are collateralized with three-month Treasury bills, which provide an additional source of income for investors. (The funds’ Treasury investments help explain why UDN rose more than UUP fell during their first year.)

UDN and UUP provide investors interested in currency investing with a much simpler option than investing directly in the futures underlying individual currencies or indices. The funds can also provide a useful means of diversifying away from stocks and bonds, because currencies and financial markets do not always move in sync. For example, rising interest rates tend to support higher currency prices while depressing stock and bond prices. That said, most investors should keep any stake here small. Currencies offer little if any potential for long-term appreciation and can trade with a great deal of volatility in the short term.

Potential investors in either UDN or UUP must feel confident that they know the answer to the following question: Where is the dollar headed? Calling currency movement is notoriously difficult, and only the most sophisticated investors have shown any aptitude for it. That said, their successful trades have gone down in investing lore—most famously George Soros’ career-making 1992 bet against the British pound, which netted him $1 billion in a single day.

The dollar has been sliding against major world currencies for six years and hit unprecedented lows in 2007. Analysts are divided about its future direction. Many analysts believe that’s reason enough to think the dollar is due for a turnaround. But speculation that the Federal Reserve will make further rate cuts, along with new data suggesting that the housing market remains troubled, could make it hard for the dollar to regain its footing. “The dollar is probably going to weaken again in the near term,” Citigroup analyst Stephen Halmarick told Bloomberg on February 19. “Overall, it does look like the U.S. housing market has a little bit of a way to go before you could say the worst is over.''

If Halmarick’s judgment is accurate, UDN could remain PowerShares’ top-performing currency ETF. But it’s worth noting that the returns of this fund aren’t likely to seem as impressive when stocks perform well. Moreover, as the global economy evolves, the six currencies tracked by the USDX might not reflect the true value of the U.S. dollar as much as they once did. Currencies of many rapidly developing economies and nations rich with commodities are soaring in relation to the dollar, and neither UDN nor UUP will take account of the strength of such units as the Chinese yuan and the Australian dollar.