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How To Play the Dollar With ETFs

Recently, the US dollar has drawn much attention as it has rebounded from a one-year low against the euro, its volatility has influenced commodity prices and a carry trade in the currency has emerged.

The Federal Open Market Committee (FOMC) has acknowledged that the US economy is emerging from a prolonged recession, however, at the same time the Federal Reserve has announced that it will maintain its near-zero interest rate into 2010.  This low interest rate, in conjunction with the dollar’s price levels and its easiness to borrow make it the perfect funding currency for carry trades.

Carry trades are when investors borrow a currency at negligible interest rates to invest in higher yielding currencies, and this can be detrimental to the currency being borrowed – in this case the dollar. 

The dollar also faces downward pressure as investors’ risk appetite increases.  As the global economy is slowly emerging out of a recession, many investors are starting to put their money into riskier investments which offer higher yields and take their money out of the dollar, which has traditionally been known as a safe-haven for international investors.  Lastly, the dollar has taken a hit by the massive amounts of money that the federal government has printed to bailout and aid the nation out of a recession.

As for the near future, the fundamentals of the dollar remain weak and the overall health of the global economy points to an unfavorable trend for the currency.  Whether or not you agree with the bearish case for the dollar, there are several ETF choices for both bears and bulls.

To short the dollar, one can choose the PowerShares DB US Dollar Index Bearish (UDN) and if one thinks that the dollar is going to rally, the PowerShares DB US Dollar Index Bullish (UUP) is a good play.  To get a bit more creative, one can consider the PowerShares DB G10 Currency Harvest (DBV), which holds long futures contracts on the three G10 currencies associated with the highest interest rates and short futures contracts on the three G10 currencies with the lowest interest rates.

Deloitte Report on ETFs

Deloitte LLP recently released an excellent report titled “Exchange-Traded Funds: Challenging the Dominance of Mutual Funds?” 

For anyone interested in learning more about how ETFs work, how they compare to mutual funds, and why they’re exploding in popularity, this piece provides an easy to read, straightforward and independent overview.

In answering the title question of the report, Deloitte concludes with the following:

“ETFs are likely to increase their share of investment dollars and become the fastest-growing investment product as funds from declining mutual funds transition to ETFs.  A research report suggests that ETFs are a threat to mutual funds because advisors, both strategic-asset allocators and ‘tactical-asset allocators, are increasingly using ETFs as part of investors’ portfolios.”

We couldn’t agree more with their assessment and invite others to review this independent report for insightful information on the entire ETF landscape.

China Still Rules Commodities

As some seemed to believe that commodity prices would fall due to a slowdown in China, it appears that they were wrong.

China’s race for commodities and resources continues as the nation announced that China Investment Corp (CIC) will purchase $850 million worth of shares representing a 15% stake in commodities-focused and Hong Kong-based Noble Group.  What’s so unique about this stock purchase is that it enables emerging China to gain access to all parts of the commodity supply chain, from farm or mine production to shipping and marketing.  And Noble’s market footprint is expansive, covering 40 countries.

China has been on a buying binge across the raw materials landscape, snapping up industrial metals such as iron ore, copper, alumninum, and zinc and ags such as soybeans and cotton.  The move is expected to help China diversify its presence across the commodity supply chain and should enhance its flexibility in managing the supply side of it growing physical commodity appetite.  The move will also provide diversification away from its central bank reserves, more than half of which are held in dollar-based assets such as US Treasuries and agency debt.

Several commodity-related ETFs could be impacted by continued growth of demand from China and other emerging economies.  Futures-based exposure to diversified commodities baskets can be accessed via DBC and GSG (be advised that GSG recently closed to new share creation and is trading at a premium to NAV) or DBB for base metals. Alternatively, exposure via equity ETFs holding stocks of companies engaged in the commodity arena would include IGE and the recently launched CRBQ.  An equity ETF having a narrower focus in the metals and mining space would be XME while MOO could be used to cover equities related to agricultural commodities.

Converts on the Rise (convertible bonds, that is)

Convertible bonds are an item that’s not usually at the top of investors’ list of hot-button items.  But in these times, it might not be a bad idea to give closer look to a player that can swing from both sides of the plate.

Convertible bonds are fixed maturity debt instruments that typically pay a coupon but also give the holder the option to convert the bond into the issuer’s common or preferred shares of stock.  Accordingly, convertible bonds carry both bond and equity valuation/performance and risk attributes … and diversification benefits that come with the ability to convert from bonds to equity.

Convertibles typically pay a coupon which is lower than a comparable non-convertible bond but higher than the dividend yield from common shares of stock of a corresponding issuer.  Because convertible bonds can be converted into equity, they tend to benefit from strengthening in equity prices.  They also get some level of downside risk support via their bond attributes – allowing them to be redeemed for par at maturity – in the event that they don’t get converted to equity along the way.

StateStreet launched the first – and still only – convertible bond ETF:  SPDR Barclays Capital Convertible Bond ETF (CWB).  The ETF tracks the Barclays Capital US Convertible Bond $500MM Index – which includes US convertible issues with outstanding issue size of more than $500 million.  With average expense ratios for actively managed convertible bond mutual funds at 1.40% (as of 2/09, according to StateStreet), CWB’s expense ratio of 0.40% clips expenses by more than two-thirds.

Since its inception on April 14, CWB has nearly kept pace with the torrid 21% return pace set by the S&P 500.

So, where do convertibles fit into an investor’s allocation?

Because of their unique return and risk attributes, convertibles can make sense as a fixed income / equity hybrid component in both buy-and-hold and trend-following strategies, or in many tactically-oriented portfolio settings.

A Few Alternatives for Dealing with Inflation Risk

As global economies start to show signs of recovery, the US dollar remains relatively weak and our government continues to spend at record levels, inflationary worries have become the new talk of the town.

Although price hikes have remained relatively low, stirring up an equally disturbing notion of deflation, eventually we will have to pay the price for spending our way out of the worst recession seen in the past 50 years.  The Federal Reserve has forecasted rising prices in the range of 2% to 3%, but most experts think it will be much higher and may even flirt with double digits.  So what do you do when inflation hits?  Some common plays include looking into precious metals and commodities.  An equally important move could be the utilization of fixed income.

Here are a few possible plays to deal with inflation:

Gold:  The most well-known and grandfather hedge against inflation, the SPDR Gold Shares (GLD). 

Fixed Income:  The iShares Barclays TIPs Bond (TIP).  This is an ETF that invests in inflation-protected securities and adjusts its coupon payments and underlying principal to compensate for inflation as measured by the consumer price index.

Commodities:  For commodities exposure its worth considering three alternatives, one providing exposure through commodities futures and two through equities of commodity-producing companies.

In the first, the Powershares DB Commodity Index Fund (DBC) provides exposure via futures to refined and unrefined oil, precious and base metals, and wheat and corn.  GSG, another futures-based commodity ETF halted creation of new shares on August 24 in response to potential CFTC changes in policy regarding position limits.

On the equities front, the iShares S&P North America Natural Resources ETF (IGE) is the established player with plenty of traction with $1.4 billion in assets.  The CRB Global Commodities Equity Index Fund (CRBQ), meanwhile, just began trading on 9/21.  The primary point of differentiation between the two is the manner of component weightings.  Matt Hougan of Index Universe reported that IGE holdings are market-cap weighted whereas CRBQ holdings are weighted according to value of commodity production, with commodity bias weighted according to total global value of each segment’s production.