Wrapping my head around foreign currency exposure in ETF's

Question

I am building a portfolio of ETF's, that track well-diversified international indices. I believe China will be a key player in the world economy for years to come, and therefore I purchased shares in the following ETF:

iShares MSCI China A UCITS ETF USD (Acc) - (See Factsheet).

However - I'm confused regarding the currency risk/exposure of investing in this ETF. I am Dutch - so my main currency is Euro. I bought the shares on Borse Frankfurt - in Euro's. However - the factsheet of the ETF states:

"The Index is calculated using China A Stock Connect listings based on the offshore Renminbi exchange rate (CNH). Your shares will be denominated in US Dollar, the Fund's base currency. The shares are listed on one or more stock exchanges and may be traded in currencies other than their base currency. The performance of your shares may be affected by this currency difference. In normal circumstances, only authorised participants (e.g. select financial institutions) may deal in shares (or interests in shares) directly with the Fund. Other investors can deal in shares (or interests in shares) daily through an intermediary on stock exchange (s) on which the shares are traded."

If I get it correctly - the return and dividends of the fund are generated in renminbi - after which they will be exchanged for U.S. dollars to pay dividends to shareholders (In my case re-invest as it is accumulating share). Return of the fund is also measured in USD. When I sell my share on the Borse Frankfurt - the dollar value of the share will be converted into Euro.

My question: what happens in this case, when the dollar depreciates compared to renminbi or euro??

P.s. this whole structure feels cumbersome and I wonder if there would be more "direct" way to invest in China - say a euro denominated China ETF?

Answer 1

Let us assume that there is some absolute measure of value unaffected by exchange rates. We could list the value of stocks and indices in this absolute measure. But at an exchange we can only trade stocks for a real currency. The same stock might trade for EUR 100 in Frankfurt and for USD 117 in New York. Because markets are somewhat efficient, the ratio of prices in real currencies will approximate the exchange rate between these currencies. This means that it's completely irrelevant in which real currency the value of an asset is measured and in which real currency you trade the asset – you will always get the same real money that represents the hypothetical absolute measure of value.

As a convenience, it is customary to declare USD = absolute measure of value. The exchange rates end up being exactly the same.

But it's worth considering that there are two factors that affect the price of an asset.

• Performance of the asset. If a company does better than expected, value goes up. If it does worse than expected, value goes down.
• Exchange rates (in particular between this absolute measure of value and whatever currency you prefer). That is what the quoted warning is saying: “The performance of your shares may be affected by this currency difference.”

When the price of an asset moves, this could be because the underlying value has changed, or because of exchange rate changes, or because of a combination of the two.

In your scenario, the value of the asset is expressed in multiple currencies: true value → CNY → USD → EUR. But regardless of the “CNY : true value”, “USD:CNY”, “EUR:USD” exchange rates, the interim exchange rates do not matter – only “EUR : true value” is relevant (or if we ignore the idealized concept of an absolute measure of value, “EUR : CNY”). The interim exchange rates like USD:CNY and EUR:USD cancel out completely (minus some fees in the real world).

So don't worry about which currency your ETF is denominated in – this is just for accounting purposes. Just remember that changes in the asset price (“performance”) are not necessarily changes in the underlying value.

It is possible to eliminate the influence of exchange rate fluctuations to some degree – you can lock in the current exchange rate for some time by doing currency hedging. This does have some value in emerging markets where there is a substantial currency risk. But in general, you don't know how exchange rates will move – it could also be in your favour. Currency hedging has an expected value of zero. But since there are associated costs, hedging would end up reducing performance of your investment by a bit. So whereas currency hedging is extremely important for investments where the true value literally is tied to some currency (e.g. bonds), it makes a lot less sense for investments like stocks where we can postulate a currency-independent value.