The Currency Factor for International ETFs

By: David Fry | Thu, Oct 27, 2005
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Currency differentia always present unique challenges for investing internationally. Sophisticated institutional investors know when investing overseas they must deal with both currency and conventional market risk. Most know they can hedge their currency exposure through the futures and inter-bank markets. Retail investors have fewer choices - hence the need for currency ETFs.

European investors are more ambidextrous in currency dealings. Prior to the Euro introduction, living and working in Europe required knowledge of and an ability to think in terms of different currencies. Retail US investors don't have experience in such matters and therefore have remained dollar-oriented.

Over the past year we've seen how currency valuations can enhance or diminish investment returns. In 2004, some of the best performing markets for US investors were in Europe, where investors profited by receiving the double-benefit of rising European indexes and a falling dollar. In 2005, good performance in European indexes hasn't been realized by US Dollar investors since the Euro currency has reversed course and is now declining.

The following charts comparing various country stock markets denominated in local currency vs. ETFs tracking those markets, denominated in dollars. The stock markets assume investors already have local currency, while country ETFs assume investors are investing in dollars which are exchanged into local currency to buy stocks and exchanged back into dollars to exit the ETFs.

Spain's ETF (AMEX:EWP), for instance, didn't match the stellar recent performance of its underlying index:

Likewise, the UK country ETF (AMEX:EWU) failed to keep up with the FTSE, its major index:

Here's the bottom line. If you read about how well certain international markets are doing and you're bothered by the lack of comparative results with your US-based ETF, currency differentials are to blame.

Of course one solution is to avoid those markets where these risks seem apparent. Another possibly more profitable outcome is for the introduction of currency-linked ETFs. It is rumored that these are already on the drawing board for some sponsors and issuers. The downside is that since sponsors and issuers only earn fees when investors "buy" new units, they generally tend to sponsor these when buying interest is strong. This is not the case currently.

Nevertheless, should currency ETFs become available retail investors will be able to devise strategies that will allow them to profitably participate in international markets without the additional frustration of having good index performance wiped-out by negative currency issues. Developing and putting forth investment strategies for these ETFs would present both opportunities and challenges. The biggest hurdle for retail investors is that "hedging" currencies involves the ability to short them. If retail shorting problems persist, then introducing currency ETFs will be a wasted effort.


 

David Fry

Author: David Fry

David Fry
ETF Digest

Dave Fry has devoted over 30 years to the business of trading and portfolio management. His registration as an arbitrator with both the National Association of Securities Dealers (NASD) and the National Futures Association (NFA) attests to his extensive experience and spotless compliance record.

Dave founded the ETF Digest in 2001 and was among the very first to see the need for a publication that provided individual investors with information and advice on ETF investing.

By 2002 ETF Digest trading programs were making triple-digit gains, despite the sharp overall market decline at that time, and Daves newsletter began attracting favorable coverage in Barrons, Forbes.com, and Wall Street Access.

Dave is a frequent commentator on ETFs and other issues important to individual investors, and his perspectives are featured in financial news sources such as CBS MarketWatch, Investor's Business Daily, Dow Jones Newswire, National Business Review, MSN Money, Yahoo! Finance, Bankrate.com, IndexUniverse.com, ETF Zone, and ETF Investor.

As the scope of ETF investing has expanded dramatically over the past few years, Dave has maintained a vital position as an investor advocate. He speaks out in favor of new ETFs to cover important market sectors and has seen new ETFs issued as a result. He is also very active in pointing out problems in the ETF marketplace to sponsors, issuers, brokers, and the media. Dave is committed to remaining at the forefront as this major investment trend continues to grow.

Some of the highlights of Dave's career before he launched ETF Digest include the following:

In 1999, he founded TechInvest Inc. and began sharing his expertise through the Internet in his TechTrend Advisor newsletter.

From 1997-99, he was Managing Director, Proprietary Investments, at JWH Investment Management (JWHIMI), an affiliated company of John W. Henry & Company. In that capacity, Dave was responsible for the management of private investments as well as some corporate accounts.

For a period of 10 years prior to joining JWHIMI, David owned and operated an NASD broker/dealer, Fry & Co., and an SEC registered investment advisory firm, Asia-Pacific Investment Management Inc. He was also a registered Commodity Pool Operator, Commodity Trading Advisor, and Introducing Broker.

Prior to operating his own investment firms, Dave was a Vice President, Investments, at Shearson Lehman Bros., and he held a similar position at Paine Webber.

During his tenure with registered firms he maintained the following licenses: Municipal Bond Principal (Series 53), Options Principal (Series 4), General Securities Principal (Series 24), General Securities (Series 7), Commodity (Series 3), State Securities License (Series 63), and State Insurance License (Life).

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