Mutual Funds
Funds for the currency cowboy in you
4 new funds target investors who want to speculate on where the dollar is headed. Be forewarned, though: Even though they're funds, there's plenty of risk.
By Timothy Middleton
The dollar's down one day, up the next. Can you make a buck on that?
Yes. In recent weeks, two mutual fund companies have opened funds that allow ordinary investors to trade the U.S. dollar. Normally, currency is traded in units of $5 million or more, shutting out most investors.
Not only can you trade: Like a hedge fund, you can double your bet with what's called leverage.
The new funds -- two each from Rydex Investments and ProFunds -- open the door to a vast arena, where $1.9 trillion worth of greenbacks, euros, yen and other currencies are traded every day. It's the biggest mart on earth, and prices can swing wildly.
Most mutual fund investors are conservative by nature, and they'll be skeptical of these new funds. But to your inner cowboy, these bucking broncos are fascinating beasts. Expert riders like George Soros have made billions betting for or against this currency or that. And especially if currencies are your thing, these funds are your front-row ticket to the rodeo.
"This is a great market for speculation," says David Durrant, chief currencies strategist for Julius Baer Investment Management in New York, and he doesn't mean that as a compliment. He reckons about 80% of each day's trading can be attributed to sheer emotion. And the new funds are better for short-term trading than long-term investing.
So you have to be this tall to take this ride, and most of us are too short. But just watching can be exhilarating.
Covering both sides of the bet
The new funds are matched sets of bull and bear funds from ProFunds and Rydex, the two fund complexes that embrace day-trading and therefore don't impose redemption fees to discourage it.
On one side is Profunds Rising U.S. Dollar Investor (RDPIX), launched in February. It aims to match the daily performance of the New York Board of Trade U.S. Dollar Index. Its companion is Rydex Strengthening Dollar (RYSBX), launched in May, which is designed to do the same thing times two -- double the gains or losses. That's the leverage.
The index itself is a trade-weighted average of performance of the greenback against the euro, yen, pound sterling, Canadian dollar, Swedish krona and Swiss franc.
On the other side are ProFunds Falling U.S. Dollar (FDPIX), which aims to deliver the inverse of the performance of the dollar index, and Rydex Weakening Dollar (RYWBX) which is designed to do the same thing times two. If the index goes down, these funds will go up.
The funds behave roughly as expected. On June 15, when the dollar index fell 0.76%, ProFunds Rising U.S. Dollar fell 0.66% and Rydex Strengthening Dollar fell 1.58%. ProFunds Falling U.S. Dollar rose 0.64% and Rydex Weakening Dollar rose 1.58%.
(By contrast, the S&P 500 ($INX) index rose 0.22% that day: less than one-third the volatility of the currency market.)
But the funds aren't always so predictable. More about that later. First, however, consider the dollar itself. You have to know, or think you know, how it's going to behave before you consider which funds to buy.
An unexpected dollar surge
In the first five months of this year, the U.S. dollar index appreciated 8.4%. Almost nobody was expecting that. Even after this bounce, the index is down 25% from its peak in 2000. The only people who got this reversal right were hedge funds.
The proof? Treasury bonds trade in dollars and therefore are used to place currency bets. The most recent Treasury statistics, for April, show huge purchases of Treasurys this year -- but not by foreign central banks, which typically are the largest foreign buyers.
In the first four months of the year, official foreign institutions purchased only $17.9 billion of Treasury debt. "Other foreigners," as the Treasury calls them, bought $106.8 billion.
To a growing extent, those other foreigners are Caribbean banks, whose purchases this year have pushed their holdings up 74.5% and made them the fourth-largest foreign investors in Treasurys, after the governments of Japan, China and the United Kingdom. Those Caribbean banks are buying them for hedge funds, which for tax reasons flourish in places like the Bahamas, Bermuda and the Cayman Islands.
The hedge funds bet against the downward trend because, though there are long-term negatives working against the U.S. economy, the shorter-term trends are bullish.
"U.S. interest rates are kicking up while the rest of the world isn't," says Abe Cofnas, founder of Learn4x.com, a Web site that promotes currency trading. "It's like if your mother has a CD coming due. She wants a higher rate, so she goes after that. That's what happens to the dollar."
Buffett and the dollar bears
The forces working against the dollar are powerful, too. The argument boils down to this: You don't get rich by borrowing and spending, which is what the United States has been doing for years.
"The currency market is like a beauty pageant, and the dollar is the least ugly currency right now," says Dan Denning, author of "The Bull Hunter: Tracking Today's Hottest Investments." "But the (trade) deficit and budget deficit are huge albatrosses around the market's neck. … Long term, I'm a dollar bear."
So is Warren Buffett, the world's richest investor. He began nearly two years ago betting against the dollar for these reasons. Last week, rumors swirled in the foreign-exchange market that Buffett was cutting back on those bets. Buffett, however, has remained mum, and some investors have their doubts. (MSN Money columnist Jon Markman thinks Buffett's Berkshire Hathaway (BRK.A, news, msgs) has lost billions in the trade.)
"Warren Buffett has taken the view that we will see a significant erosion of the value of the dollar, and we have that same view," Durrant says. "I don't think those rumors are correct. I think his underlying view is still structurally there are imbalances in the U.S. economy, and those imbalances will weaken the dollar going forward."
But making a long-term bet for or against the dollar with these four new funds isn't as predictable as you would wish.
Will the funds hit their targets?
All four funds use financial derivatives to deliver on their promise -- but strictly on a daily basis. That is their weakness as well as their strength. A quirk of mathematics can turn a winning idea into a losing investment. It works like this:
If a $10,000 portfolio goes up 10%, it's worth $11,000. But if that $11,000 then goes down 10%, that's a loss of $1,100, taking your original stake to $9,900. So down days can hurt more than up days help.
A 10% daily pendulum swing is unlikely. But, in reality, these funds can deliver the opposite of their expected returns. In 2001, the Nasdaq 100 Index plunged 32.7%. That year Rydex Venture 100 (RYVNX), designed to deliver 200% of the inverse of the index, actually fell 5.0%. ProFunds UltraShort OTC (USPSX), also leveraged 200%, behaved similarly. And those funds use the same basic mathematical models as the new currency funds in order to do their job.
Over the three subsequent years, those bearish funds moved opposite the 100 index, as intended, but imperfectly. They both went up about 50% in 2002, when the 100 index went down 37.6%. In 2003 and 2004, both funds again delivered almost identical returns, but never twice the inverse, as predicted. In 2003, they went down about 63%, which was 150% of the inverse of the index, and in 2004 were down 25%, about 250% of the inverse.
David Reilly, director of portfolio strategy for Rydex funds, says: "You're exactly right. Over time, particularly when you have volatility in the market, compounding can pull you away" from intended results.
Michael Sapir, chairman of ProFunds, insists, "Compounding should not be an issue because (ProFunds' currency funds) are not leveraged." But the unleveraged ProFunds Short OTC Fund (SOPIX) was down only 37.4% in 2003, when the Nasdaq 100 was up 49.1% -- a tracking error of 24%. ProFunds OTC (OTPIX), the opposite of Short OTC, was, however, nearly dead-on with a gain of 47.2%.
So these funds might be rifles over short periods, but they're more like blunderbusses over a stretch of time. Certainly the unleveraged funds are more predictable than their leveraged cousins, although potentially less lucrative.
A safer way to bet against the dollar
Investors, therefore, are left with a lot of choices. My choice would be to follow the traditional path and invest instead in a foreign-stock fund that does not hedge currencies. I expect the dollar to decline, and a non-U.S. fund would get an extra boost from a weak dollar.
The fund I would recommend is iShares MSCI EAFE Index (EFA, news, msgs), an exchange-traded fund that I own in my model ETF portfolio. It has gone up an average of 10.5% in each of the last three years mainly because of stronger foreign currencies. It is down 2.5% this year, as of June 14, partly because those currencies are weaker.
But for the adventuresome, the new ProFunds and Rydex portfolios open yet another door to investing. Particularly if your job or inclination gives you special insight into day-to-day movements in foreign-exchange markets, they can be very profitable trading instruments.
