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This post was originally shared on my eToro feed in on 25 September 2022. Make sure to follow me there as well, and did you know that you can copy my trading there for free? Create an account today, copy my portfolio by searching for user “Allseasonsport” to automatically duplicate my All Seasons Portfolio strategy effortlessly.

Since I joined eToro in April 2021, I have been sharing insights and observations about investing with risk balanced strategies such as the All Seasons Portfolio strategy which I blog about here. As eToro is a social trading platform, I from time to time share content directly in my eToro feed, which I then share on the blog in posts like this.

In the last year, most major asset classes have struggled. This includes stocks, government bonds, corporate and HY bonds, real estate, and gold (in USD). Most of this decline can be traced to interest rate risk, which I wrote about extensively in a recent post on the blog.

As mentioned in that blog post, interest rate risk and sentiment risk (risk off periods) are considered undiversifiable risks, as you cannot (or at least not easily) diversify away the negative impact of these risks with a long-only portfolio. By adding a trend following component, you could, however, benefit also in environments of drawn out declines, which is why the SocGen CTA Index is up 24% YTD per end of September.

While there are plenty of ETFs in the US that can give a retail investor access to the trend following space (for example the HRAA ETF submanaged by Resolve Asset Management), there are few options available for those stuck in the UCITS regime here in Europe.

Therefore, we need to look for alternative assets that could provide some protection against rising rates, and one of them could be to go long the United States Dollar. In this article, we will be looking at an index giving broad exposure to the dollar, what benefits it adds to a diversified portfolio, and how a retail investor can add this exposure to a portfolio.

The easiest way to invest in the dollar is to track the U.S. Dollar Index (also the “USDX”, the “DXY”, or – informally – the “Dixie”), which is an index of the value of the United States dollar relative to a basket of foreign currencies. When the index rises, it means that the dollar gains strength when compared to the other currencies.

The currencies making up the basket is a weighted geometric mean of the dollar’s value against the following currencies:

• Euro (EUR), 57.6% weight
• Japanese yen (JPY), 13.6% weight
• Pound sterling (GBP), 11.9% weight
• Canadian dollar (CAD), 9.1% weight
• Swedish krona (SEK), 4.2% weight
• Swiss franc (CHF), 3.6% weight

The weights have been constant since inception in 1973, with the only modification in 1999 with the formation of the euro. It is debated whether additions and/or substitutions should take place by, for example, including Chinese CNY, South Korean KRW, Brazilian BRL, and Mexican MXN, as these countries have become increasingly important trading partners to the US over the last decades.

Trading the DXY is an easy way for an investor to get exposure to the dollar’s relative value against major currencies without the need to trade each currency pair. One could thus argue that it is a good way for retail investors to take a bet on a stronger dollar, especially by investing in an ETF with the DXY as the underlying exposure.

This can be done by trading the $UUP ETF (Invesco DB US Dollar Index Bullish Fund) which closely tracks the DXY since 2007. Note though that this is an ETF listed in the US, meaning that it may not be available with all European brokers under the UCITS regulation. It is, however, tradeable at eToro also for Europeans.

Including the DXY exposure in one’s portfolio is wise under two circumstances: firstly, by trading it with a shorter horizon when one thinks that the dollar is about to rise in value, and secondly (as I prefer), to hold it for a long-term investment in a broadly diversified portfolio as another contribution of an uncorrelated asset class that protects against certain macro environments.

The DXY is biased to outperform when:

1. The Fed tightens policy: The USD strengthens against other currencies when the Fed hikes rates and tightens monetary policy more in relative terms than other central banks.
2. Risk Off periods occur: During volatile and uncertain time, investors tend to sell off assets and park their funds in the world’s strongest reserve currency, which for the time being (and the foreseeable future) is the US dollar.
3. The basket currencies weaken: The DXY rises when the USD rises against other currencies, which in other words can also be triggered when other currencies weaken due to circumstances related to them. For example, the Eurozone, UK, and Japan are currently facing economical challenges, e.g., due to the war in Europe’s backyard in Ukraine casting shadows over energy supplies and economic growth, and Japan which has employed yield curve control for years weakening the Yen. The US still has the most stable economy and, perhaps, the most stable approach to interest rate hikes, at least when compared to ECB, BoE, and BoJ.

Historically, the index has traded in a range of about 80 (reached for example during the 1979 oil crisis, 1987 Black Monday, and 2007-2009 GFC) to 150 (when Fed funds rate crossed 11% in 1984). Most of the time though, the index has spent in the range of 80-100 with a brief spike to 120 around the turn of the millennia. Before Bretton Woods Agreement was broken and the gold standard was left to history in 1971, the index was stable around the 120 mark.

In recent years, the DXY fell from a level of 95-97 until March 2020 when a decline commenced on the back of the eruption of the Covid-19 pandemic. In 2021, the DXY rose from a low of 89 in June to reach 95 by the end of the year. In 2022, the increase has been sharp and hyperbolic with the DXY currently standing at 113 as at late September 2022.

With the Fed’s hawkish stance where we could see higher rates for longer (the market currently prices in the first rate cuts already by Q2 2023), and with that first rate cut shifting further out into the future, or when the rates go higher than the market had expected, the dollar will strengthen ceteris paribus.

Translating this into the UUP ETF, let us also take a look at the ETF development since inception. The line (blue) is compared with the DXY (green) in the chart below. The differences between these are explained by the DXY being an index, while the UUP tracks the index by investing in futures contracts that (imperfectly) tracks the index. There will always be some drag from replicating an index via futures contracts due to negative effect from rolling contracts, and cost of carry, etc. Besides this, the ETF tracks the movements in the DXY closely, and would would have benefitted from holding a position during, for example, into the Fed rate hikes of 2015 and Brexit uncertainty in 2016.

In the context of an All Seasons Portfolio with a long-only all-weather approach, the addition of a DXY exposure is beneficial for two key reasons already mentioned in this post.

Firstly, it adds an uncorrelated asset class, which increased the returns earned from a rebalancing premium that occurs when selling (relatively) outperforming assets and buying (relatively) underperforming assets.

Here below, I add four correlation matrices over the last 12 (longest available data) and 3 years using monthly and daily returns against other major asset classes. As you will find, UUP has low and negative correlation with all assets, meaning that when added to a portfolio it will decrease the total portfolio correlation, implying increased rebalancing premium.

Secondly, it adds a hedge against two risks that are commonly perceived as undiversifiable, namely interest rate risk and sentiment risk (periods risk off attitudes in the market).

The bias of the DXY is, in addition thereto, fundamentally disinflationary (the USD appreciates against the price of goods), save for when rising rates are used as a weapon against rising inflation (DXY outperforms after the first shocking face of inflationary periods).

Therefore, I have from mid-September started to allocate a part of my eToro portfolio to the UUP ETF and will build this further to around 5% of the portfolio. I have so far decreased the allocation to stocks and bonds that do not perform well in this current environment of rising rates, with the expectation that the UUP will offset some of the losses in these other assets. Exactly how my long term allocation will be is yet to crystallize, but in this current environment of rising US rates and challenging possibilities for the rest of the world to follow suit, I decided to at least take a small position.

However, the volatility of the DXY is quite low at only 7% annualized, which is about half that of the stock market and on par with treasury bonds, why I expect that unless you allocate a larger amount or lever this position (for example with CFDs on CMC Markets [affiliate link] for European investors), it will only be a small contributor to the overall returns, but with positive effect over the long-term. Note that also on eToro, you as an European investor can increase the exposure by levering the position (e.g. 2x or 5x), as the platform supports levered CFD trades.

As a final addition, if you are looking for a UCITS complying alternative, it looks like the closest match would be the Lyxor Fed Funds US Dollar Cash UCITS ETF (ticker: FEDF). It does not follow the US Dollar Index, BUT could still be a hedge against rising rates as it is invested in Fed Funds futures contracts (the same contracts I used to base my analysis on in my article about interest rate risk). Note, though, that as it invests in Fed Funds futures contracts, you get paid for changes in future steering rate expectations, not necessarily communicated rate hikes. Perhaps I should write a separate post specifically about this product as well, what do you think?

Thanks for your attention, and I hope this post has been useful. And make sure you look up my profile on eToro, if you haven’t already by searching for user “Allseasonsport”.

Cheers,
Nicholas

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The opinions shared in this article are those of the author and do not constitute investment advice in any form. Any mentions of my trading strategy are for descriptive and information purposes only of what I do with my money. All investments carry the risk of capital loss.

This post includes affiliate links for eToro, and by clicking the links, I may get a compensation, at no extra cost or disadvantage for you. On eToro, the trading on my account is done with my own money, and if you chose to copy my trading, I have skin in the game and incentives to stick to my strategy and perform well.