Currency effects of ETFs and Unit trusts (Why this ETF goes up when the stock market crashed after Brexit?)

I always get this questions very frequently from my clients. I ended up explaining the story over and over again until I decided to write this article to clear the misconception once and for all.

The questions that are always asked are:

Since this ETF/Unit trusts is in foreign currency, wouldn’t I be exposed to the currency risk of that currency?
I dislike Sterling. So I am not interested in any Sterling denominated ETFs.

First, the reporting currency of an ETF and unit trust is immaterial. You must remember that an ETF and Unit Trusts cannot be treated like a stock. ETF and Unit trusts are known as Collective Investment Schemes (CIS). A CIS is merely a vehicle to purchase large number of securities. What is important are the underlying assets and the underlying currencies. The reporting currency is immaterial when making an investment decisions.

Second, it is important to convert all gains or losses to your own home country’s currency. This is the most accurate form of calculation as it would have taken care of all the currency effects and avoid confusion.

Third, there are ETFs and Unit Trusts that have currency hedging. For such a case, the currency dynamics changes and you now take on the full currency risk of the currency that is hedged against.

I shall give a few examples.

iShares MSCI Emerging Market (IEEM)

The IEEM is traded in Sterling.

As at end of 24 June 2016 closing price, it appears that the ETF has increased in value by 3.59% as shown below. This is strange because UK just voted to leave the European Union and all the stock markets in the world have crashed overnight. So does that mean there is a gain in this ETF? The answer depends on your home currency.

The ETF is reported in Sterling. But the Sterling has dropped by -6.45% against the Singapore dollar (SGD). Since there is no underlying exposure to Sterling, the ETF has to increase in value. This may give an impression that the ETF made a gain. So you need to calculate the change in value in SGD to determine whether was there a gain. The following is how you can calculate:

Current Price of ETF in GBP:              22.8875
Price of SGD to 1 GBP:                    1.85158204
Price of ETF as at end of 23 June in GBP: 22.0600
Price of SGD to 1GBP:                     1.9792

Therefore, the change of ETF price in SGD (i.e. home country currency) over the one day period:

$\frac{22.8875}{22.0600} \times \frac{1.85158204}{1.9792} - 1 = -2.94\%$

So it can be seen that the ETF has actually decrease in value. Which is the expected outcome.

IMPORTANT: The reporting currency is immaterial when making an investment decision. Hence, the reporting currency is not a factor in making an investment decision.

Fidelity America Fund

The Fidelity America Fund invests in US companies. The reference currency is USD. It has a few share classes but I will use three of its share classes as examples:

Fidelity - America SR Acc USD. This fund’s reporting currency is USD which is also the same as the reference currency. The currency risk to the Singapore investor is the USD.
Fidelity - America SR Acc SGD. This fund’s reporting currency is SGD. The performance of this fund and the previous one should be almost identical. Thus, the currency risk to the Singapore investor is the USD despite the fact that the reporting currency is in SGD.
Fidelity - America SR Hedged Acc SGD. The fund implement currency hedging against the SGD. This means the currency risk to a Singapore investor is SGD and NOT USD. Since a Singapore investor’s home country currency is SGD, it implies that this fund’s currency risk has been removed.

The following chart is a comparison between Fidelity - America SR Acc USD and Fidelity - America SR Acc SGD. The chart converts the performance to SGD. It can be seen that both funds are identical despite having different reporting currency.

In the following chart is a comparison between Fidelity - America SR Acc USD and Fidelity - America SR Hedged Acc SGD. You can observe that the Fidelity - America SR Hedged Acc SGD performance is worse than Fidelity - America SR Acc USD in most of the period. This is because the currency risk of USD has been removed. Since USD appreciated during the period (shown by the pink color) (or SGD depreciated during the period), the Fidelity - America SR Hedged Acc SGD did not benefit from the USD currency appreciation. But should USD depreciate against the SGD, the Fidelity - America SR Hedged Acc SGD will not suffer the currency lost.

Conclusions

The reporting currency of a collective investment Scheme like ETFs and Unit Trusts is not important. It is not a factor when making an investment decision.
Convert all gains and losses to your home currency if you want a report on the performance of the investments.
If there is currency hedging, you take on the currency risk for which is hedged against but the reporting currency is still NOT important.

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