USD has declined almost 10% compared to rest of the world. What is the best way to hedge this risk?
I am very new to this, so this post is more asking for a discussion than me providing an answer.
U.S. investors are used to a strong dollar, and most don't pay attention to its fluctuations. But the greenback's value, relative to other major currencies, has fallen 10% over the past five months—and many expect the slide to continue. Investors have three options—stick to the original portfolio and simply ride out the currency fluctuations; shift into asset classes that tend to do better under a weakening dollar; and/or seek out investments designed to take advantage of a falling dollar.
After the greenback suffered its worst month in a decade, investors are wondering why the drop. Here's a close look at the forces behind it.© Financial Times 2020. These presentations are provided for informational purposes only.
The dollar's recent fall is primarily a result of the U.S. government's monetary easing policies in response to the pandemic-triggered economic disruptions. Lower interest rates have made the currency less attractive to hold. In addition, the dollar supply surged as the Federal Reserve opened swap lines with other central banks. And the huge fiscal stimulus and mounting national debt have boosted demand for foreign capital.
What's more, as life in many parts of the world has begun to get back on track, the U.S. still doesn't have Covid-19 under control. "The second-quarter GDP is the weakest we've seen on record," says Schroders investment strategist Whitney Sweeney. "That—along with the increasing coronavirus infections—is really adding to concerns about weaker economic growth in the U.S. Simply being the haven is not going to be enough to bolster the dollar going forward."
Indeed, this might be the beginning of an extended dollar decline, says Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research. She expects the currency to drop another 5% to 10% in the next year or two. "The Fed's forward guidance says they'll keep the rates low and liquidity ample for a couple of years. That's a signal to the market that they don't have a lot to fear in other currencies," she says. "Investors have been heavily weighted in dollar assets, and now might be the time to diversify a little more broadly."
Investors could dial up their allocation to international assets, which typically benefit from a weakening dollar. Since foreign-based companies report their earnings in the local currency, U.S. investors will enjoy a larger gain when translating those numbers into dollars. For a well-diversified exposure, the $24 billion Vanguard Total International Stock ETF ( VXUS ), which owns some 7,000 stocks from more than 45 countries, returned 18% over the past three months, beating the SPDR S&P 500 ( SPY) by more than two percentage points.
Investors should check whether an international fund is hedged against currency fluctuations or not. The hedged funds can protect returns when the dollar strengthens but will underperform when a cheaper dollar gives international assets an extra lift. While hedged and unhedged funds generate similar returns over the long run, in the short term, there can be big differences. Over the past three months, for example, the $49 billion iShares MSCI EAFE exchange-traded fund ( EFA ) gained 16.2%, while the $2.3 billion iShares Currency Hedged MSCI EAFE ETF ( HEFA ) returned just 9.9%. "If the dollar continues to weaken, the unhedged funds should do better than the hedged funds," says Morningstar ETF specialist Alex Bryan.
A falling dollar can lead to inflation—higher prices for everything from apparel to airline fares. The core consumer price index, while still running lower than a year ago, jumped 0.6% from June to July, marking the fastest monthly rise since 1991. Yet, many economists say it's too soon to worry. "We doubt that the rise in CPI in July is the start of a trend to higher inflation," says Jones. "With the unemployment rate over 10% and excess capacity in so many industries, it's unlikely that inflation can move up in a meaningful way this year."
Investors who want to be extra-cautious can shift some of their Treasuries into Treasury inflation-protected securities, or TIPS, whose face value rises with the consumer price index. Due to the Treasuries' very low yields, however, Jones says that investors should "purely look at it as a hedge, rather than something that can produce income."
Hard assets like commodities are another hedge against inflation. Precious metals, in particular, have soared lately. ETFs such as the $33 billion iShares Gold Trust ( IAU ) and $14 billion iShares Silver Trust ( SLV ) are backed by physical commodities and closely track their prices. The $967 million Invesco DB Commodity Index Tracking ETF ( DBC ) offers a broader exposure, with futures contracts on 14 heavily traded commodities. Stock in companies that mine and trade commodities are another option, though usually more volatile.
Finally, to specifically profit from a falling dollar, investors can directly bet on foreign currencies through the $76 million Invesco DB US Dollar Index Bearish ETF ( UDN ), which shorts the U.S. Dollar Index futures contracts and makes money if the dollar drops against six other major currencies. Be aware of the concentration risk; the euro alone accounts for half of the move.
Morningstar's Bryan recommends the iShares International Treasury Bond ETF ( IGOV ) as a more diversified alternative; it owns a broad basket of government bonds from non-U.S. developed markets. Since interest rates in these countries are close to zero, the fund largely moves against the dollar's value. But that also means no additional gains besides the currency movement. Bryan warns: "You are not really getting paid for holding the Treasuries, but it's a safe place to park the money while you are riding out the movements of the dollar."
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