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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.

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.

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.

Source: Holding Cash Is No Way To Build Wealth