ETF Trends
ETF Trends

When thinking about the role the U.S. dollar plays in an investor’s portfolio, an important distinction must be made: total returns and increases in future foreign purchasing power are not the same thing. U.S.-based investors’ awareness and consideration of the U.S. dollar’s impact on their portfolio usually occurs when they assess the merits of an unhedged international equity or a fixed income position. To offer investors a differentiated approach, WisdomTree has emerged as an industry leader in the currency-hedged equity exchange-traded fund (ETF) space. However, from the perspective of many U.S.-based investors, if they are buying U.S. dollar-denominated assets, they are implicitly long the dollar. In our opinion, this interpretation is only partially correct. It is true that the total returns of their investment are not impacted by changes in foreign exchange rates, but if the U.S. dollar appreciates against a foreign currency such as the euro, the investor is no better off with respect to total returns; his future purchasing power in euros has simply increased.

In global markets, currencies are traded in pairs. When investors enter into a long position in a currency, they must sell another currency short to initiate their position. To potentially benefit from this move, if the investor was long the U.S. dollar against a short position in the euro as mentioned above, he would have generated total returns in addition to his increases in purchasing power. Keeping this important distinction in mind, in what scenarios should investors consider investing in the dollar against a basket of international currencies?

Currency as an Asset Class

At WisdomTree, we have long advocated that investors should consider allocations to foreign currencies, particularly in emerging markets (EM), as a complement to their traditional equity and fixed income portfolios. Higher EM interest rates, combined with greater long-term productivity rates, remain the key reasons why investors should consider diversifying their currency exposure through strategic long-term allocations to EM currencies. However, as we will detail below, there are also several instances where investors should consider a short position in foreign currencies against the U.S. dollar as part of a tactical asset allocation approach.

Low Opportunity Cost

With interest rate targets in most developed countries near zero, opportunity costs in many of these markets are negligible. Due to the arbitrage mechanism in many forward currency markets, investors with a short exposure to a foreign currency have a short position in foreign interest rates as well. Therefore, a long position in the U.S. dollar against a short position in a foreign currency results in a negative drag on performance if the foreign country’s interest rates are higher than the United States’.

With talk of tapering in the United States weighing on investors’ minds ever since Fed Chairman Bernanke’s speech in May 2013, traders started buying U.S. dollars and selling foreign currencies in advance of a potential rise in interest rates. However, in Europe, the European Central Bank (ECB) recently lowered interest rates by 0.25% in order to help stimulate the eurozone’s economy. Mark Carney, the current Governor of the Bank of England, has pledged to maintain low policy rates until unemployment drops below 7%. And after years of slow growth, the Bank of Japan is continuing to signal its increasing commitment to Shinzo Abe’s reflation agenda. As a result of these policies, the U.S. dollar may not only appreciate, but also diminish the costs associated with a short position in foreign currencies.

The implied 1-Month deposit rate represents the annualized interest rate embedded in forward currency contracts.

For definitions of indexes in the chart, please visit our Glossary.

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