Investing in an ETF listed overseas

Investing in ETFs overseas has become more accessible and cost effective for investors. It’s opened up a range of options – there are 240 ETFs listed in Australia. There are over 3,000 listed in the US alone.

With everyone having unique circumstances and financial goals, many investors believe the larger the product range, the more puzzle pieces to fit into perceived gaps in their portfolios.

Although it can seem that increased choice is a win for investors, sometimes more choice results in convolution of portfolios, unnecessary complexity and unintended consequences.

Locally listed ETFs fit the needs of the most investors looking to get broad exposure to the asset classes needed to form the core of a diversified portfolio. For investors that are looking at some of the more niche offerings available in the US it is important to consider how much exposure is appropriate.

Read this step-by-step process for choosing an ETF.

For investors that are interested in purchasing an ETF listed on a global exchange there are several considerations.

Currency

When it comes to currency, think of purchasing ETFs listed overseas in the same way that you would purchase a share listed overseas. When you buy or sell an ETF on an exchange like the NYSE or NASDAQ, currency conversion will take place.

Locally listed unhedged ETFs that hold global assets will have the same currency impact on the underlying return of the ETF. A depreciating Australian dollar will add to returns and an appreciating Australian dollar will detract from returns.

Yet there can be a pitfall to investing in an overseas listed ETF.With many ‘free’ brokers, this is where they make an attractive profit, with some earning up to a 0.7% clip on your buy trade, and then another 0.7% when you sell. That leaves investors on the back foot, requiring a notable appreciation to cover the currency conversion price. This clip does not occur when you are trading ETFs domiciled in Australia as no currency conversion is needed.

You may miss an opportunity to compound your returns

With ETFs listed overseas, distributions are not automatically reinvested. One of the keys to successful investing and building wealth is reinvesting your dividends and distributions so your earnings can compound.

We explore the concept of dividends in detail in this episode of Investing Compass. The example that we have used on the podcast is Transurban. While this is an individual share the same impact would apply to an ETF as well.

An example of the difference reinvesting dividends can make

Say that you buy 1000 shares in Transurban Group (ASX: TCL) on the first day of trading in 2009. It is a low point in the global financial crisis; Australia is experiencing the first negative quarterly GDP growth in 8 years; and it’s a month before the introduction of the $42 billion economic stimulus package by the Rudd government.

Option 1: Taking the payments as income

In the first scenario, your dividend payments are deposited into your account.

As Transurban continues to raise the dividend, your passive income increases. Each year the percent increase in the dividend compounds. As a result, your income is increasing faster than the sum of the annual totals.
In 2009, Transurban declares $230 worth of dividends on your initial investment of $5020. By 2017, Transurban declares $545 a year in dividends. If you add up each annual increase in the dividend for the period in which you have owned the stock, there is a total increase of 91.49%. That sounds great but pales in comparison to the total increase in your income, which has increased by 136.96%. That difference of 45.47% in income growth represents the compounding of each increase building on the previous one.
The day after the last dividend declared in 2017 is paid on February 19, 2018, the value of your investment has increased from $5020 to $11,650—an additional gain to the income you have earned.

Option 2: Reinvesting the dividends

In the second scenario, you have dividend payments automatically re-invested at the share price the day after the dividend payment date.

In 2009, you will be paid $233.25 in dividends, which will grow to $807.07 in 2017. The difference between the amount you earn in the first scenario and the second scenario is the compounding effect of continually increasing the amount of shares you own and therefore increasing the amount of income you are entitled to. The value of your initial investment has now increased from $5,020 to $17,861 on the day after your last 2017 declared dividend is paid on February 19, 2018. Your last declared dividend for 2017 is paid on February 19, 2018. The value of your initial investment has increased from $5020 to $17,861—a gain of $12,841.

This scenario shows that reinvesting income leads to a significant difference in your outcomes. The reason the difference is so significant is because those reinvested dividends then go on to earn more dividends, and the cycle continues as it compounds. The fact that you are unable to reinvest income from your ETF holdings listed overseas can impact your total return outcomes, especially over long-time horizons.

Getting the best price

We’ve spoken briefly about online brokers that entice investors with $0 brokerage for their investments. There are multiple revenue streams that allow these brokers to operate with this “brokerage free” model. This includes Payment For Order Flow. This means that they sell your order flow (the trades you are making) to other companies, rather than buying and selling at the lowest market price.

In most instances, investors do not receive the spot price - the order does not execute at the best price possible. Instead, the order is sent to the third party to complete the transaction.

Getting enough sleep

Trading overseas means that you’re often trading at times where the market may be closed.

On the topic of time zones, Morningstar ETF Specialist Bryan Armour advises to invest in the time zone where the underlying assets are trading. For example, if you’re investing in an ETF listed in the US, that trades US equities. It would be ideal to be able to invest in them when market makers are keeping ETFs in line with their underlying stocks when they’re being bought and sold in real time. Unfortunately, this is a case of bending the parameters of space and time so Aussie investors may have to forego this tip if they are sold on purchasing an ETF listed in the US.

For markets with no overlap, market makers rely on the fluctuations of other markets as a guide to set prices – this is not a reliable way to set prices. Ben Johnson, CFA, suggests for investors who are investing in ETFs to use limit orders, but it is particularly important for investors who are investing in markets that do not operate in the same time zone.

Limit orders allow investors to set a specific price, which means that they are not subject to the fluctuations that happen at market open as ETFs move to keep in line with underlying stocks, and pre-market orders execute.

Tax

I’ve written in detail about tax with international investments here. The main points to make here is that you will be subject to withholding tax. This can be claimed at tax time in Australia.