Selecting asset class components – currencies

There are two main methods of adding currency exposure to a given portfolio. The more complicated way is to devise a basket of currency crosses that adheres to some criteria, such as GDP weighting, trade flow weighting, etc. The easier way, at least for US traders, is to use the US dollar index. Since I am only trading stocks and ETFs, constructing a basket of currency crosses would be very difficult due to the limited availability of currency pairs and lack of liquidity. Thus I have adopted the US dollar index approach via UUP.

UUP is composed of long positions in the US dollar futures. One problem with this index is the weighting scheme:

Euro – 57.6%
Japanese Yen- 13.6%
British Pound – 11.9%
Canadian Dollar – 9.1%
Swedish Krona – 4.2%
Swiss Franc – 3.6%

This weighting scheme makes little sense today, which is probably due to a legacy effect. The index was created in the aftermath of the currency crises that accompanied the end of the Bretton Woods regime and the introduction of fiat currencies with floating exchange rates in the early 1970s. At that time, such a weighting may have made sense based on relative GDP numbers or trade flows. Now it reflects neither. While this is clearly a flawed index, UUP is by far the most liquid currency ETF and provides exposure to the worlds major currencies.

If someone reading this post has some insight into the creation of the weighting scheme and why it has not changed, please leave a comment.

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