U.S. Dollar Investing: Beware the Perils of UUP and UDN

With the high volatility of the U.S. Dollar lately, and its recent near-collapse, investors are right in looking for ways to preserve their money and look at currency ETFs.

This article looks at the UUP and UDN funds. They are bull and bear versions of the U.S. Dollar index offered by Powershares. It invests in futures contracts "with a view to tracking the changes, whether positive or negative, in the level of the Deutsche Bank US Dollar Index (USDX) Futures Index."

I have done a thorough analysis of these ETfs for 2008 and 2009 and have compared their performance with the expected performance. I wrote a piece of software to do the analysis of over 1M data points. The results are shown in this article.


WHAT SHOULD HAPPEN

In a trending environment, it should be a good plan to buy both versions of bull and bear ETFs. This is due to compounding effect day after day. For example, in a theoretical scenario where a stock moves up 1% per day, for 100 consecutive days, and you hold both bull and bear 1X versions of the corresponding ETFs, your total performance would be +52.3%. The bull version goes up +167%, the bear version goes down for a return of -63%. Because the losses in terms of dollars are smaller and smaller every day, and the dollar gains of the bull version afer greater day after day, the overall strategy is a winner. Please see the chart below, which shows what happens with $10 invested in each ETF, for a total $20 initial investment.



It is a clear winner in a trending environment. Note that this has nothing to do with leveraged ETFs, these are just plain simple 1X ETFs.

Now, in an alternating highly volatile market, the opposite should occur, however, the total losses are much smaller. The following chart shows the same investment after 100 days, assuming the market goes up 1% one day, then down 1% the next day, up 1% the next, and so on.



The total return now is a loss of -0.49% after 100 days. So, not so bad.

Now what happens with in-between mixed scenarios. The folloing table shows various cases. The more trending the market, the higher the gains. The more volatile the market, the lower the gains. No surprises.


(please click to enlarge)

Here is a summary:




PERFORMANCE OF UUP AND UDN

All nice and dandy. So what happened with UUP and UDN? Let us take a look at 2009, whe the U.S. Dollar was crashing (until yesterday that is).

From Jan. 1 2009 to September 22 2009, UUP went up 8.47%. UDN went down -9.31%. Its was very much a trending environment, with a few ups and down, but mostly trending, as we know. The fact that UDN loses more than UUP gains hapens repetitively, in happened in 145 out of the 182 trading days. That is nearly 80% of the time. This ends up causing significant losses to investors.

I then used my software to run simulations. It analysed what happened with $10k bought in each fund, for every day of 2009. The results are not good:



The table shows the average final dollar ammount (for the total $20k initial investment, $19k in UUP, $10K in UDN) after holding the ETFs for several different lengths of time.

You may view complete results here. It is a large pdf with tens of pages, but shows every single day.

On average, the strategy is a losing one. How was this possible?

In its prospectus, Powershares says the MER is 0.55%, less a gain of 0.16% in interest, for an effective 'fees and expenses" rate of 0.36% for 1 year. If we factor these fees in, we still do not get anywhere near the losses shown in practice. Doing the math, we see that the effective MER for the 182 days is 0.2508%. Each of ETFs will lose this amount over the period (2009 YTD). This is nowhere near the losses we actually see.

So it is another case of buyer beware.


Note: You may receive technical analysis and alerts of UUP ad UDN, sent automatically to you by entering the symbols in the Technical Trend Analysis Tool, (powered by INO).