Exchange-traded funds (ETFs) make it very easy for investors to get exposure to overseas markets. But that means it's important to understand what potential currency exposures you face. For a UK-based investor in a FTSE 100 ETF, where both the shares in the index and the ETF itself are denominated in sterling, things are straightforward, of course. But for international ETFs there are three types of currency exposure to be aware of.
Only the first of these, the local currency of the underlying securities held by the fund, represents true currency risk. If you invest in an MSCI World ETF, for example, you will have exposure to companies in 23 countries. So this may include firms using roubles, yuan, pesos, or rupees in their everyday activities.
The second way in which an overseas currency can appear in an ETF is via the net asset value (NAV) or base currency, its unit of account. For the MSCI World ETF, for example, this is US dollars, even though the companies underlying the index come from many currency areas. When the ETF's official NAV is calculated each day, several exchange rates are used to restate local share prices into dollars.
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The third way in which an ETF can use different currencies is via its market listing, or 'dealing currency'. The iShares MSCI Japan ETF trades in sterling, euros and yen on different exchanges across Europe, for example. This means that dealers effectively do a currency conversion for you when you buy the fund in sterling in the UK - you don't have to buy the yen yourself to buy Japanese shares. Using a 'secondary' dealing currency typically means a slightly larger spread.
For example, ETF Securities' sterling-priced physical gold ETC (LSE: PHGP) typically has a wider bid-offer spread than the dollar-priced version (LSE: PHAU). But this just reflects the fact that most world gold trading is done in dollars. In any case, buying the sterling version is likely to be cheaper for most UK investors than having to exchange pounds for dollars, then purchasing the dollar-priced ETC.
The key thing to remember is that when investing in an ETF with underlying assets outside Britain, you will have exposure both to the local market and to the currency involved, and this can work for you or against you. For example, if you buy a US equity tracker and the market falls by 10%, but the dollar rises by a similar amount against sterling, your position will stay flat measured in pounds.
Paul Amery edits www.indexuniverse.eu
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