Watch the currency on USD ETFs

Posted on: January 14, 2010 in: Uncategorized with 0 comments

An archerETF client called me the other day about one of the holdings in his account, EPI, the Wisdomtree India ETF. His concern was that the US dollar was weakening and EPI is traded in US dollars.

Canada is a great place to live. We have decent healthcare and a strengthening currency. (Coincidence? I think not!) One thing we don’t have though is a good selection of ETFs to choose from. Ours are pretty plain vanilla.

On the other hand, the USA not only has a greatleader (who doesn’t hide under rocks like some prime ministers we know), but also has an incredible ETF selection. In US markets, you can buy an ETF for just about every country index, plus all sorts of commodities and other exotic exposures. The downside for Canadian investors is the currency risk. Or is it?

As I explained to my client, every US dollar ETF gives Canadians currency risk, but not necessarily to the US dollar. The currency risk is instead to the currency of the assets held inside the ETF. So, in the case of the India ETF (Ticker EPI), the risk for the Canadian investor is that the Indian rupee will weaken against the Canadian dollar.

And this makes sense if you consider the mechanics.
When you buy EPI, you first sell your C$ and buy US$. Then EPI’s manager sells the US$ and buys the Indian Rupee. As you can see the US$ buy and sell cancel each other out leaving the C$ exposed to the Rupee.

This Yahoo Finance chart demonstrates the same thing. For a Canadian investor, the relevant exchange rate is the Rupee, not the USD when buying EPI.

Take a look at the Yahoo chart below (or click on the chart for a bigger image).

Red line: EPI, the India ETF in USD
Blue line: the NSE Nifty Index in INR
Green line: exchange rate of USD per 1 INR
Brown line: exchange rate of CAD per 1 INR
Gold line: exchange rate of CAD per 1 USD

The NIFTY is up 22% in INR terms. Rupee strength vs the USD adds another 3%. A US investor should see a total return of about 25% and in fact, EPI delivers 27%. (The remaining 2 percentage point difference is because NIFTY and EPI aren’t identical in their holdings).

For ETF-challenged Canadians – a different story. The NIFTY is up 22% in INR terms. Rupee weakness vs the CAD subtracts about 8%. A Canadian investor should see a total return of about 14%.

First take the EPI return of 27% in USD terms. Now, the USD weakened by 10% against the CAD, leaving the Canadian investor with about 17%. Not the same as the 27% for our American cousins, but then, we have healthcare.

The same lesson applies to every ETF where the actual holdings are in another currency different from the currency the ETF is traded in.

For Canadian investors, that means we can buy USD ETFs without always worrying about future of the US dollar.

As always, your comments and questions are welcome.
Vikash Jain, CFA

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