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Investing Compass: Does the exchange an ETF trades on matter?

Thinking of purchasing an ETF listed in the US, the UK, or any country other than Australia? Listen to this episode first.

Co-Author | Mark LaMonica, CFA

Shani Jayamanne: Welcome to another episode of investing compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Alright Shani so we have another competition.

Jayamanne: We do.

LaMonica: I think this is potentially our most exciting prize yet.

Jayamanne: I think so cause it’s got nothing to do with… subscriptions

LaMonica: It’s not a Morningstar hat or anything like that. So it is – and make sure I get this right, it’s an Amazon Echo Dot.

Jayamanne: That’s it.

LaMonica: So that’s that little thing that you yell at in your house and then it does stuff for you, mostly like just play a song for you or look up the weather.

Jayamanne: I use it for shopping lists as well, so if I’m cooking and I run out of something I tell it to put it on my shopping list.

LaMonica: Okay well.

Jayamanne: Anyway, it does a lot.

LaMonica: Apparently, apparently.

Jayamanne: But one of the things it does is it allows you to say “Alexa, play Investing Compass” and it will play our latest podcast.

LaMonica: So that’s awesome.

Jayamanne: That’s the tie in – that’s why we’re doing this.

LaMonica: Yeah okay, that’s a dubious connection at best. But anyway, here’s what you need to do. We would love you to put a comment in your podcast app, then email it to me and we will randomly draw from anyone who made a comment – my email address is in the episode notes, we’ll randomly draw a winner.

Jayamanne: 5 winners.

LaMonica: 5 winners. Wow.

Jayamanne: I know we’re being very generous.

LaMonica: Okay we’ll randomly draw 5 winners at the end of June.

Jayamanne: Yep, that’s it, that’s the competition.

LaMonica: There we go. And speaking of people that have emailed me today we have a listener requested episode, and it’s from Glen. So Glen asked ‘could you discuss the differences and implications of owning an EFT that is traded on an exchange in Australia versus on that is traded on an overseas exchange?’ 

Jayamanne: And Glen, we can. 

LaMonica: And here’s a little tip – not only will we give you an Amazon Echo Dot with a comment and an email, but we’ve done an episode on basically every episode request we’ve gotten. So, if you’ve got a question, ask it. 

Jayamanne: Exactly, Mark. 

LaMonica: So back to Glen’s question – and it’s one that a lot of investors are thinking about. 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. 

Jayamanne: 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. 

LaMonica: 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. 

Jayamanne: We think that locally listed ETFs fit the needs of 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. 

LaMonica: So as we said, We think that the offering for the Aussie market is enough for most investors, and international ETFs listed in Australia makes it easy for Aussie investors to get the exposure without a large administration burden.  

Jayamanne: That’s right Mark, one of the reasons that you pay management fees on funds and ETFs is, well – for them to be managed. The underlying assets are bought, sold or rebalanced to match the fund strategy, and you do not need to declare the income and capital gains from each asset contained within the investment. 

LaMonica: Investors will receive an Attribution M.I.T (managed investment trust) annual statement that will declare all investment income, any capital gains that have occurred, and any foreign tax offset within three months after the end of financial year. 

Jayamanne: But again, this episode isn’t about trying to sell you on domestic ETFs, it’s talking about what investors need to consider before investing in ETFs that are listed overseas. 

LaMonica: Okay – so let’s think about the considerations for purchasing an ETF domiciled overseas. The first is currency.  

Jayamanne: 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. 

LaMonica: 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. 

Jayamanne: But it can also make things a bit complicated. 

LaMonica: I got an email a while back from a listener who wanted to get exposure to individual country ETFs. I believe specifically he was looking at Malaysia. So let’s say you invest in an ETF listed in the US that is giving you exposure to Malaysia. Well now the currency impacts on your returns are a little trickier. The underlying assets held in the ETF are Malaysian so one factor that will impact your returns are changes in the exchange rate between US dollars and Malaysian Ringgits.  And that is the impact that any US investor would have that invested in the ETF. But you aren’t a US investor. So then you have another impact to your returns the changes between the Aussie dollar and the US dollar. So just adds another factor. And remember that the changes between the Aussie dollar and the Ringgit don’t really matter because that direct exchange rate isn’t what you are concerned with as the US dollar is the intermediary.

Jayamanne: Yet there can be a pitfall to investing in an overseas listed ETF. 

LaMonica: 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. 

Jayamanne: Alright – the next issue is missing out on compounding. With ETFs listed overseas, distributions are not automatically reinvested. There have been a few episodes where we’ve gone into detail about how reinvesting dividends can have a marked difference on your outcomes – one of our first ever episodes actually – What is a dividend? Gave a detailed example of the difference between taking dividends as income and reinvesting using Transurban as an example. And although this is an individual share, the same concept applies to ETFs.                 

LaMonica: That’s right Shani. The crux of it is that one of the keys to successful investing and building wealth is reinvesting your dividends and distributions so your earnings can compound. And this is obviously a choice of investors. And there are certainly ways you can do this without automated reinvestment of dividends by just using the proceeds from distributions to buy more shares. But the ability to put this process on auto pilot can be a real benefit.  

Jayamanne: 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. 

LaMonica: 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. 

Jayamanne: Okay, another consideration for investors. Time zones. Trading overseas means that you’re often trading at times where the market may be closed. 

LaMonica: 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. 

Jayamanne: 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, who is a Director at Morningstar, 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. 

LaMonica: 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. 

Jayamanne: The last one is tax, and tax is a big one. We’re going to speak a little bit more generally for tax in terms of international investments in general.  

LaMonica: There are a few considerations. The first is that in almost every jurisdiction, companies will have to pay a corporate tax rate on any income earned. As a reminder, these investments are not included under the dividend imputation system and this means no franking credits, and the corporate tax paid cannot be offset or recouped. 

Jayamanne: For a lot of investors, this is a deal breaker. We encourage you to go and listen to our international investing podcast episode to understand why we think you should look past franking credits. Okay, Mark. What happens from a tax perspective when you have an international investment, and you receive a dividend?  

LaMonica: In the eyes of the ATO, any investment income you earn in or out of the country has to be taxed. In most cases, the country you’re investing in will also require the investment to be taxed. In the US, this is done automatically through withholding tax of 15%. Not all countries withhold tax. The United Kingdom is one example. 

Jayamanne: To limit double taxation, investors are given a foreign tax offset in the case where there’s withholding tax from the investment’s country of origin. You can claim this as a credit against the Australian tax payable on foreign income if you are an individual investor or investing through a trust. 

LaMonica: We make this disclaimer because this scenario may play out differently if you are investing through a company account. Withholding tax leakage occurs when your company covers the corporate tax rate on foreign investments. For example, in the US, the corporate tax rate is 21%. In Australia, it is 30%. When you receive your tax offset, 9% is held back to make up the difference. Income that is then distributed to individuals from your company account does not receive any withholding tax credit. Alright Shani, what happens when you sell your investment? 

Jayamanne: When the time comes to sell out of your investments, it can trigger capital gains tax – hopefully it does because it means you’ve made a gain. Capital gains tax on international investments are taxed the same as Aussie investments. You still receive a CGT discount on assets that are held for more than 12 months, and the remaining gain is added to your assessable income for the year. 

Again, similar to income tax, some countries where you’ve invested may have a capital gains tax or an equivalent type of tax. If you’ve already paid this tax overseas, you might be eligible for an offset. Let’s move onto currency. 

LaMonica: Every part of your tax return must be filed in Australian dollars. When you’re declaring income from international investments, two rates must be used depending on the circumstance. 

Jayamanne: The first - you’re receiving the income into Australia: 
The exchange rate at the date you received the dividend or distribution in the case of an ETF. 

LaMonica: The second, you’re keeping the dividend in an international account: The exchange rate at the end of financial year is used. We won’t go into this in detail, but currency is obviously a component of your performance as well. We’ve done an episode on currency impacts on international investments if you want a deep dive into this.  

Jayamanne: And as always, there are costs and expenses associated with international investing, just like there are costs and expenses associated with domestic investing.  

LaMonica: and much like expenses associated with earning Australian income, expenses associated with your foreign investment income may be claimed. 

Jayamanne: There are some general exclusions to the rule, including if your expenses outweigh the income you generat. You may not claim the excess in the same financial year. For specifics on what is eligible, consult a tax professional. 

LaMonica: Exacatly so Shani is definitely right there – so we’ve spoken a lot about tax but like with many things in investing, the tax that you pay is based on a lot of variables and your personal situation and circumstances. So to echo Shani again, we encourage you to speak to a tax professional to understand how this may impact your finances. 

We also encourage to enter our competition which I think is a good one. So remember comment, email it to me and we'll draw a winner on June 30th and they'll get an Amazon Echo Dot.

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