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An Ounce Of Prevention

Apr. 27, 2015 12:34 PM ETUUP, UDN
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A good strategy for any equity investor is to have a diversified 'core portfolio' consisting of the world's leading companies, for examples, Apple, Toyota, GE, BP, ING and the like. Although the core portfolio strategy is a good one there's a hidden problem that will almost certainly affect the total portfolio return over time. Global economies are strongly interconnected. For example, the component parts for a particular model of automobile might be manufactured in several different countries. Those parts are then exported to still another country for assembly and once again exported to the point of sale. However, what's not so obvious is that from component part to the point of sale, several currency transactions will be involved. Further, if the automobile sale must be financed, currency transactions will again matter. Lastly the earnings of this globally connected automobile company are affected by the currency of country in which it is based.

In fact, virtually all products and financial services of all multinational corporations are affected by multiple cross border currency transactions.

There are derivative instruments and strategies used to mitigate the volatility inherent in currency exchanges. Futures, Forwards, Swap and Options were all developed with exactly that purpose in mind. For the most part these derivatives are exchange traded and any trader with the knowledge and required capital may engage this market. However, if you're like most people you hardly have the time in your daily schedule of the work-family-home routine to be rolling in and out of currency hedging strategies.

So it all begs the question: how may an individual investor mitigate or even take advantage of currency fluctuations inherent in a well-constructed core portfolio?

Although the potential for high returns may be tempting, currency trading is not advisable for an inexperienced retail investor. Many retail brokers offer 'paper trading' platforms for testing strategies, but not all entry or exit paper trade executions will happen with the same certainty in the real world as they do in the 'paper world'. Knowledgeable and informed investors with experience only with equity trading need a product in between derivatives and actual currency trading. Fortunately the right products do exist. Currency tracking ETFs are exchanged traded products which will serve well as 'portfolio hedging tools'.

Here's a simple example. On 23 April, PepsiCo Inc. reported that quarterly revenues fell 3.2% and attributed the shortfall to a strong dollar. On the same day Procter & Gamble also reported that the strong dollar accounted for around a 6% reduction in revenues. Kimberly-Clark reported a 9% dollar related reduction in revenues. A few other examples of large corporations with overseas currency exposure are Intel with 83% overseas sales, Qualcomm with 97% overseas sales, Kansas City Southern with 46% overseas sales and Pfizer with 55% overseas sales. Currency related risks are nearly unavoidable.

From 1 January through 23 April the US Dollar index has gained a respectable 9.4%. Hence, were small investors able to participate in the US Dollar index in some way, it would have clearly offset any dollar related setback incurred by multination corporations. Most importantly, keep in mind that quite often, strong dollar effects do not necessarily mean an outright quarterly revenue loss, but more likely a reduction of expected positive revenues. Hence a prudent application of an ETF product will hedge against core portfolio currency exposure.

Let's take an example: PowerShares (UUP) tracks the changes in Deutsche Bank's US Dollar Index Fund. The basket of currencies against which the USD is measured includes six major currencies: the Euro, the Japanese Yen, the British Pound Sterling, the Canadian Dollar, the Swedish Krona and the Swiss Franc. The fund trades US Dollar Index future contracts, only. The fund also pays interest from its US Treasury holding and deducts fees and expenses. The fund is designed with the average investor in mind.

100 UUP shares purchased on the first trading day of January would have returned 6.85% or $1.65/share as of 23 April or $165 on the $2410.00 investment. This alone would have been a respectable ROI year to date. Consider a portfolio consisting of 100 shares each of five multinational currency sensitive companies. If twenty shares were considered allocated as a hedge for each of the five companies, each currency related share loss would have been offset by $33.00 YTD.

There were two good examples at hand at the time of this writing: PepsiCo and Kimberly-Clark.

PepsiCo's share value has essentially no gain YTD. By PepsiCo's admission, the strong dollar has weighed on earnings. Hence a 20 share UUP hedge allocation contributed $33 YTD or nearly 0.35% towards PepsiCo's contribution to the portfolio.

Kimberly-Clark was harder hit by the strong dollar. KMB attributed a 9% revenue reduction in the quarter to the strong dollar. YTD Kimberly-Clark has lost $3.87 share, about -3.34%. Again, the 20 share UUP hedge allocation offsets that loss by $33, offsetting the YTD loss to 3.06% or $3.54 per share.

A hedge is not a 'cure-all'. However it will add up over a longer time frame. To gauge just how long, consider the macroeconomic conditions in Europe. Even with an extraordinary QE bond buying program, the results so far are not certain and unemployment is still above 11%. Further, EU metrics are buoyed mainly by two countries, Germany and the U.K. The remainder of the Eurozone is in or near recession. The point being that it might be some time before the purchasing power of the Euro returns to normal. In the east, China and Japan are also experiencing slowing economies. Both have ongoing QE programs which will weaken their currencies against the dollar thus making US products more expensive in that region. It is reasonable to assume that there may be several more quarters of continued dollar strength globally.

It needs to be said that there is no such thing as 'buy-and-forget'. An ETF does minimize the personal time one must allocate towards keeping up with the research, but by no means eliminates it. The natural question to ask is does the potential exist at some point for UUP to do more harm than good? The answer to the question is best explained this way. All of the currencies in the UUP basket also trade against each other as well as against the dollar in foreign exchange markets. So under 'normal' circumstances UUP's volatility is dampened. However the volatility may increase in front of US economic event dates, for instance, important economic data releases or Fed meeting dates. A good approach is to set a 'trailing' stop loss order. In this case about 3% of the entry price will do. Keep in mind that should the dollar suddenly weaken, those companies in a dollar sensitive portfolio will react positively. Hence, even in an 'extreme' circumstance, for instance, a Fed rate hike or a strong employment report, an appropriately placed trailing stop will unwind the hedge and have small effect on the overall portfolio gain.

This may be taken a step further for those investors familiar with equity options. The hedging currency ETF may itself be hedged. For example, it seems a reasonably good risk to short out-of-the-money calls against an ETF dollar hedge. Expectations are for a September Fed Funds rate increase. This expectation caps US Dollar appreciation against the basket and the time (theta) decay will accelerate towards expiration. Hence the cost to unwind is mitigated by capturing a few premiums in the intervening months.

Lastly, it's worth mentioning the UUP mirror imaged ETF called, appropriately enough, PowerShares DB US Dollar Bearish ETF (UDN). The composite basket is identical to the bullish fund as well as proceeds earned from interest on US Treasury holdings. The difference is that the bearish fund shorts US Dollar index futures. The strategy is simple but does require attention and 'patience'. UDN reacts positively when the dollar weakens against the basket and UDN share value is not too far off its YTD low. The hedge may be applied as follows: simply dollar cost average purchases each time UDN dips below its 23.6% Fibonacci retracement level. When the inevitable Fed rate hike does happen, the entire dollar sensitive portfolio will react positively and will be further enhanced by the gains of UDN having been averaged in at or very close to its lows.

The days of the isolated financial spheres of influence are long gone. Currency transactions which may have once taken days to complete are now completed in milliseconds. Further, few large corporation exist, if any, which are not subjected to some degree of currency volatility. Investors should no longer stand idly by and simply dismiss dollar related revenue shortfalls as unavoidable. Managed ETF currency funds give ordinary investors the tools necessary to 'prudently hedge' currency sensitive portfolios.

Mike Scrive

Analyst's Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

“CFDs, spread betting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary. Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.”

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