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Summary Few investors in the U.S. explore ETFs listed abroad. There may well be a larger and cheaper fund available to gain the desired exposure. Local currency denominated ETFs offer important benefits from the risk management standpoint. 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 U.S. 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 U.S. 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 U.S. 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 U.S. 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 U.S. investor wants to invest in blue chip stocks in the United Kingdom. Checking the ETFdb.com , there appear to be 7 U.S. listed ETFs that invest solely in the U.K. Although 3 out 7 funds offer currency hedged exposure, by far the largest and most popular ETF in the U.K. category is the 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 U.S. 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 U.K. 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 the iShares Core FTSE 100 UCITS ETF (LON:ISF), 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 U.K. 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: (click to enlarge) 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 U.K. 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 Another important reason to consider local currency denominated ETF is the possibility to purify exposures. Looking at risk parameters of EWU calculated on a freely available investor resource utilizing 12 months historical data, it appears that the fund’s annualized volatility was 18.4%, whilst its beta against the SPDR S&P 500 ETF (NYSEARCA: SPY ) almost equal to 1. However, if we look at ISF.L in isolation, it turns out that the underlying index actually has a bit lower volatility and is substantially less dependent on S&P 500. I have included the Guggenheim CurrencyShares British Pound Sterling Trust (NYSEARCA: FXB ) in the table below as a proxy for GBPUSD. Source: InvestSpy The fact that relationship between FTSE 100 and S&P 500 is not so close is further confirmed by correlations, which show that ISF had a coefficient of only 0.58 as opposed to 0.80 of EWU. Source: InvestSpy This means that an investment in FTSE 100 has more potential to offer diversification benefits to a U.S. investors than it may appear at the first sight. Not surprisingly, the well-known and documented home country bias among investors only gets aggravated when market participants look at distorted statistics. Not only investing in local currency denominated ETFs gives a clearer picture of the underlying index, but it also forces an investor to make a conscious decision about the FX risk. In contrast, using a U.S. listed ETF for international exposure leaves the investor with a convenient alternative of not doing anything. As documented by behavioral economists and Nobel Prize winners Kahneman and Tversky, “opt in” vs “opt out” questions can lead to completely different outcomes. Systematic models Finally, for investors that rely on quantitative or technical analysis, it is important to distinguish whether their models are suitable for stocks, FX, or both. A moving average on SPY is not the same thing as a moving average on EWU because the latter is effectively a wrapper for both equities and FX components. If your model has been tailored for equities, ILS would be a more appropriate choice with the FX decision left as a standalone issue. Conclusion The aim of the article was to offer a different perspective into international investing via ETFs. Using the case of the U.K., I have illustrated that in some cases a local currency denominated ETF listed outside the U.S. can be a better way to achieve the desired exposure. One reason for this is that some foreign ETFs are cheaper and larger than their U.S. counterparts. Another important point is that using a local currency denominated fund purifies exposures arising from the underlying index and foreign currency. One point of caution though is the tax treatment of investments in funds domiciled abroad. Every investor should assess their individual circumstances as part of the decision making process. But if your tax situation does not preclude you from investing in ETFs listed abroad, such an approach may bring more transparency to your portfolio. It is a rare feat in the world of finance nowadays. Scalper1 News
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