The Currency Factor for International ETFs
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.