The cost of foreign currency-denominated shares and ETFs

He asks: "I frequently see shares and ETFs denominated in both sterling and dollar share classes. If the dollar is rising against sterling, would it be better to buy the dollar share class? What is the difference from the perspective of a UK retail investor?"

There are several layers of currency to contend with when buying a foreign equity ETF, but the one that matters is the underlying currency of the ETF or share you are buying. The underlying currency, also known as the base currency, is the currency that the assets tracked by the ETF are valued in. For example, if you are buying an S&P 500 ETF, the underlying assets you are investing in will be valued in dollars, even if you buy a share class denominated in sterling. Whether you buy iShares Core S&P 500 UCITS ETF USD (CSPX) or iShares Core S&P 500 UCITS ETF GBP (CSP1) will not make any difference to your total return.

However, it could make a big difference to your trading cost due to the commission your broker will likely charge you to convert your dollar share class returns back to sterling. For this reason, it is always best to buy the sterling share class of an ETF as a UK retail investor. Broker charges vary, but tend to cost between 1 and 1.5 per cent of a deal transaction added on to any other dealing charge.

It might seem odd that buying a foreign share class has no impact on your returns, but the currency dynamic which matters is that between your domestic currency and the currency of the underlying assets you invest in. The exchange rate between the currency you are being quoted in and your domestic currency is irrelevant.

If you buy an S&P 500 ETF in a dollar share class, the value of the ETF which you receive will only ever be the result of the value of the underlying assets (in dollars) converted into pounds. Different currency share classes were designed for institutional investors and are not a way for retail investors to take currency views.

Currency hedging

The only real way to protect yourself against currency fluctuations is by buying a currency-hedged ETF. However, you should only do this if you have a very strong view on another currency or sterling. Doing this incurs costs and if you are wrong you could lose out on returns.

Currency-hedged share classes are different to buying foreign currency classes because they use derivatives or buy short positions in other currencies to neutralise the impact of any currency movement on the index returns. You get only the stock return and none of the currency effect. This is important if you are buying assets in a currency which is weaker than your own - because you will get lower returns when converted back to sterling. The problem is that currency fluctuations are hard to predict, and if the currency you are investing in strengthens against sterling you will lose out on any beneficial returns, as well as probably pay a higher ongoing charge for your currency hedged fund.

Japanese equities are a case in point. The government of Prime Minister Shinzo Abe has pursued policies which have weakened the yen since 2013. But at times the yen has also strengthened so despite significant yen weakening in 2013 and 2014, unhedged ETFs performed better in the two following years.

For example, iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) has a higher ongoing charge of 0.64 per cent than iShares MSCI Japan UCITS ETF's (IJPU) ongoing charge of 0.59 per cent. In 2012 and 2014, investors would have taken home far better returns using the hedged ETF, but in 2016 that fund lost 3.4 per cent, while iShares MSCI Japan UCITS ETF made 22.1 per cent.

Ever since the UK's vote to leave the European Union, sterling has weakened and UK investors have earned better returns from overseas stocks due to favourable dynamics between sterling and currencies including the dollar. In the immediate wake of the Brexit vote, the pound hit a 31-year low against the dollar, meaning that investors should think carefully before opting for currency-hedged ETFs.

Example of broker charges for foreign exchange

Source: Company websites as at 05.01.17