ETF Trends
ETF Trends

Investing internationally – US dollar vs local currency denominated ETFs

Investors are frequently advised to allocate at least a portion of their portfolios to international securities in order to benefit from the only ‘free lunch’ in the markets – diversification. Developed economies, emerging markets, frontier countries and a range of other definitions are commonly used in day to day conversations. However, with the ETF universe constantly expanding both in the US and overseas, there are so many different options to give you the desired exposure that it has become a challenge to choose the most suitable fund.

Investments in international markets come with an important element of complexity – currency risk. From a US investor’s perspective, this means that even if the selected market performs well, the ultimate result can be affected by the local currency’s movement against the US dollar. I have already discussed currency risk management in one of my previous articles, thus this time I would like to draw your attention to the differences between US and internationally listed ETFs. Hopefully this will give you an alternative perspective about investing abroad.

Finding an international equivalent

As a practical example, I am going to use a case where a US investor wants to invest in blue chip stocks in the United Kingdom (“UK”). Checking the ETFdb.com, there appear to be 7 US listed ETFs that invest solely in the UK. Although 3 out 7 funds offer currency hedged exposure, by far the largest and most popular ETF in the UK category is iShares MSCI United Kingdom ETF (NYSEarca: EWU), which leaves the pound-dollar FX risk unhedged. In fact, EWU with has 9 times more assets under management ($2.7 billion) than all other funds combined. This suggests to me that either US investors are willing to accept the FX risk or they prefer to manage it on their own. If either is true, it then makes sense to explore local currency denominated ETFs that invest in UK stocks.

To explore the European ETF space, one of my favorite tools is justETF.com.  The screening tool on this website finds 11 ETFs investing in FTSE 100 constituents. The largest fund on the list is iShares Core FTSE 100 UCITS ETF (ISF:LON), which is primarily listed on the London Stock Exchange. Compared with EWU, this fund has a couple of obvious advantages. First, its expense ratio of a mere 0.07% is well below 0.48% charged by EWU. Second, with $5.8 billion in AUM, ISF is twice as large and a more frequently traded fund.

Returns

In terms of portfolio holdings, both EWU and ISF have almost identical composition. Both ETFs hold just over 100 UK blue chip stocks weighted by market cap, thus the differences are so marginal that they can be neglected. However, does that mean that their impact on the portfolio is the same? The chart below illustrates performance of both ETFs as well as GBPUSD exchange rate over the last 12 months:

Source: Google Finance

Given that the operating model of EWU is to gather funds from investors in USD, convert them into GBP and then invest in UK stocks, its theoretical return should be very close to the combined result of ISF and GBPUSD. In reality, EWU underperformed by more than 1% (EWU: -6.78% vs. ISF: -1.01% and GBPUSD: -4.38%). There could be several factors accountable for the discrepancy, including tracking errors, expense ratios and the difference in trading hours.

Separating the FTSE 100 index performance and GBPUSD impact gives an investor a much clearer picture of return drivers. In this particular instance, it is the FX component that accounted for the bigger part of EWU loss in the last year.

Risk management

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