THE CURRENCY FACTOR OF INTERNATIONAL ETFs
by Dave Fry
July 20, 2005

Currency differentials 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 Euros introduction, living and working in Europe required knowledge, 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. 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.

I believe that now we’re seeing hints of potential currency benefits for US investors in some China-based US market ETFs like PGJ, and FXI. The widely discussed revaluation of the Chinese Yuan seems already anticipated by some investors.

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 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.

© 2005 Dave Fry
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