Investment Road Test: iShares ETF FTSE/Xinhua 25

PORTFOLIO POINT: ETFs with an international focus are affected by price and currency movements, so would-be investors should do their homework.

Strength has returned to the Australian dollar. At the time of publication it was trading for US99.20¢ after hitting a two-month low of US95.45¢ – which means that now may be a great time for Australian investors to consider acquiring an offshore exposure.

This benefits the investor in two ways. First, they are making use of their increased purchasing power (see Buy up big while the dollar’s hot); and second, if the dollar retreats then the value of their investment has also increased. Of course, like leverage, it’s important to realise that this also works in reverse.

A cheap way of accessing international shares is through the range of foreign currency-denominated ETFs issued by iShares. ETFs are not new, and iShares has been on the front foot in Australia but has failed to excite for a number of reasons.

Let’s have a look at how exposure to the China sharemarket can be obtained using iShares as part of a currency enhanced investment play.

iShares ETFs provide exposure to international equities and indices, and also to the foreign currencies in which they are denominated. This means the Australian dollar price of an iShares ETF reflects the price of the underlying securities (in their local currency) and the exchange rate between the Australian and that local currency.

This means iShares value is multi-dimensional and potentially harder to manage than the one-dimensional share price risk that investors are used to managing.

In Australia the iShares listed in the ASX are pooled together with the other iShares ETFs from around the world, which are then invested into shares in the countries to which they give exposure. So, for example, the iShares FSTE/Xinhua 25 (ASX code: IZZ) involves the following components:

• The underlying ETF holds 25 shares (click here) listed on the Hong Kong Stock Exchange with their activities primarily in mainland China. Those shares are denominated in Chinese yuan;
• That underlying iShares ETF is listed on the NYSE and trades there in US dollars (but its price fluctuates reflecting the yuan-based prices of the underlying Hong Kong-listed shares);
• The ASX listed iShares ETF is like a “depositary receipt”; when an investor buys the ASX-listed iShares ETF this results in a purchase of units in the underlying NYSE-listed ETF, resulting in the Australian iShares investor having a direct exposure to the underlying Hong Kong-listed securities and to the Chinese yuan.

There are useful fact sheets available on the iShares website showing how currency and share price fluctuations can be to the benefit (or detriment) of Australian investors. If you have limited experience with currency exposures I would urge you to visit the website and familiarise yourself with these case studies.

The website gives the example that as the Australian dollar strengthens against the yuan, the net asset value of the iShares ETF will represent less Australian dollars and the market price on the ASX is likely to fall.

This is the phenomenon that has been experienced over the past few months for iShares denominated in currencies against which the Australian dollar has appreciated. So buying iShares in markets that have some appeal and value will be advantageous now, at least compared to their prices when the dollar was much weaker – say back in May when it was worth US81¢.

There is also a nice trading opportunity, which is expected to play out over time, if the Australian dollar tends to fall against other currencies back to levels typically experienced prior to the GFC.

The problem in this scenario will arise if the Australian dollar continues to appreciate against the foreign currency, which will erode gains in the price of the underlying securities.

So an investor should have a reasonably strong view that the Australian dollar is near its peak, which may or may not be true. History tells us the dollar is trading well above its long-term average, but the structural support behind it may keep it high and rising for some time yet. It also requires investors to have a view of how fast Beijing will let the yuan appreciate against the US dollar.

The iShares FSTE/Xinhua 25 is a neat way to buy the largest Chinese companies available to foreign investors. By accessing the so called “H” shares listed on the Hong Kong Stock Exchange it avoids the higher prices prevailing in the restricted mainland “A” shares market, which typically trades at higher relative P/E ratios than H shares (current P/E ratios for stocks in the iShares FSTE/Xinhua 25 are about 16 times).

Now may be the time to buy iShares investing in growth countries like China. They are cheaper now than they have ever been, but because of the continuing strength of the local currency investors should ignore all but the fastest-growing economies.

The score: 3 stars
0.5 Ease of understanding/transparency
1.0 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
0.5 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.