The following question is from Jamie:
My portfolio is quite similar to your Sleepy Mini Portfolio with a few variations in asset allocation. However, I’ve come across the currency neutral versions of the US and International funds. I’m not sure what the advantages and disadvantages of the three options ($CAD, $USD, Neutral) are and how to evaluate the three funds.
The TD e-Series of index mutual funds has three flavours of funds that track the S&P 500 - TD US Index (TDB902), TD US Index US$ (TDB952) and TD US Index Currency Neutral (TDB904) - and two funds that track the MSCI EAFE Index - TD International Index (TDB911) and TD International Index Currency Neutral (TDB905). TDB952 is different from other funds because it is denominated in US dollars (i.e. you buy using US funds and when you sell you receive US funds) and simply tracks the S&P 500.
TDB902 tracks the S&P 500 in Canadian dollar terms. In other words, the returns obtained from the fund will be the total return of the S&P 500 adjusted for the changes in the Canadian dollar vis-à-vis the US dollar during the same time period. TDB904 hedges the currency exposure for a small extra fee of 0.15% and is designed to provide the same total return as the S&P 500 in its local currency, in this case the US dollar.
For example, let’s say that the S&P 500 was at 1000 and the Canadian dollar at par when you purchased TDB902. One year later, the S&P 500 is at 1100 and the loonie fetches 90 cents US. Your return from the fund, ignoring dividends and assuming there is no tracking error, would be 22%: 10% from the increase in the value of the S&P 500 and 11% from the increase in the value of the greenback. If you had purchased TDB904 instead, you would have made 10% because the currency effect would be hedged away.
Similarly, TDB911 captures the return of the MSCI EAFE Index, which tracks markets in Europe, Japan and Australia, in Canadian dollars and TDB952 hedges the exposure of our dollar to a basket of currencies such as Euros, Pounds, the Yen and the Aussie Dollar.
The fund to use to capture the foreign currency exposure is a matter of personal preference. I personally prefer using unhedged positions because (a) It is cheaper (b) In the long run, currency effects will average out (c) The value of hedging is questionable when a basket of currencies are involved and (d) While currencies on their own have zero expected return over cash, adding them to a portfolio reduces volatility and offers diversification benefits. Admittedly, not hedging the foreign equity positions has not worked out very well in the past few years and you can justifiably hold the opposite view point.
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14 responses so far ↓
1 FourPillars // Jan 29, 2008 at 8:05 am
My view on hedging is similar to yours (I don’t do it) but given the swings from the last year I have to say that I will definitely look into when I get closer to retirement. For at least part of my equities anyways.
Some investors tend to increase their Canadian equity content closer to retirement which I don’t agree with since our markets are not diversified enough. I think if you want to eliminate currency risk, currency neutral funds and etfs are the way to go.
2 Silicon Prairie // Jan 29, 2008 at 10:55 am
I’m avoiding currency neutral funds because they have to lose some returns to the hedging - I didn’t know they had a higher expense ratio but I’m not sure that covers all the costs. I too believe that exchange rate variations won’t matter much in the long term. If you aren’t investing for the long term you shouldn’t be holding stocks anyways, much less international ones!
3 louis // Jan 29, 2008 at 11:52 am
sort of related question: How does TD deduct their MER fees? Do they do it at the end of the year, or throughout the year? and is it pro-rated if you by into an index-fund part way through the year?
4 Canadian Capitalist // Jan 29, 2008 at 12:12 pm
Mike: The current foreign exposure in our portfolios is 50%. As we get closer to retirement, it will decrease as we boost the bond component. I don’t think I’ll ever hedge our foreign equity positions.
SP: The typical cost of hedging is 15 basis points per year.
Louis: I would assume they’d deduct expenses on an ongoing basis but I am not really sure.
5 FinancialJungle // Jan 29, 2008 at 4:51 pm
>>”While currencies on their own have zero expected return over cash, adding them to a portfolio reduces volatility and offers diversification benefits.”
Can you provide a link that suggests leaving currency open will reduce volatility? Even so, I don’t believe the volatility is evenly distributed. It’s the extraordinary times like now that will hurt us the most. But, no matter how tame the volatility is (yet to be proven), there’s no denying that currency cycles are much longer than stock market cycles. “Currency washes out over the long term“ rolls off the tongue easily until people realize that long term means 15 years. Why would anyone settle for a near zero expected return when they must commit to a 15-year investment horizon in order to revert to the expected return?
That makes absolutely no sense. The people who opt to expose their portfolios to currency risk are the same people who shun leverage investing. The typical stock market cycle is only 7 or 8 years - half that of a typical currency cycle, while the expected return of a leveraged portfolio is 400 basis points (assuming 6% interest and 10% market return). Short cycles are your best friend, because they offer more opportunities to revert to the mean.
6 Silicon Prairie // Jan 29, 2008 at 5:46 pm
Think about what it means to hedge for currency exposure. After 10 years you expect that the exchange rate could be higher, lower, or roughly equal but you generally can’t predict which one. If the exchange rate is higher or equal then it doesn’t take away from the gains in market value (in fact if it’s higher you get an additional gain). It’s only if the exchange rate is lower that you actually need the protection. So buying a currency neutral fund rather than an ordinary fund is a bet that the native currency will decline in value. If you’re confident about this why not try forex trading?
If you buy assets in their native currency or using straight exchanges you’re always exposed to their value as seen by the rest of the world (ie, the value of a US stock to someone living outside the US). I’m not sure how much pressure market forces put on prices from that perspective but there must be some keeping values in line. If you’re outside the US it seems natural to buy US assets as they’re valued by the rest of the world. Trying to remove the currency exposure means you’re (1) buying a US asset and (2) buying insurance against the US dollar declining in value.
You would be right not to put all your investments in the S&P 500 if you’re in Canada, but it seems like diversifying by investing in other countries (europe, japan, australia, emerging economies…) would be more effective than paying for insurance against negative exchange rate movements. It removes the cost of insurance, reduces currency risk by using many instead of one, and you can use an asset allocation to take gains from a country that’s going well and moving them to one that has more room to grow.
That means the only big risks remaining are that all the external countries you invest in fall apart at the same time or the value of the Canadian dollar goes down significantly. The second one is slightly more likely, but if you’re investing in stocks you should have time on your side anyways. You can plan for a slightly longer cycle and move towards more concentrated Canadian investments before moving away from equities. Even if you do that, you get another kind of risk in the less diversified Canadian market. All this really shows is that investing can be unpredictable.
All this is if you’re just looking at one currency at a time - an EAFE index just makes it that much more complicated.
7 Canadian Capitalist // Jan 29, 2008 at 6:13 pm
FJ: I’ll dig up the reference to reduced volatility from one of Larry Swedroe’s books.
Do you have any studies backing up your claim that currency cycles last 15 years? I found one study by Brandes (unfortunately in my library, not sure if it is still available online) that from 1980 to 2005 there were nine cycles of positive and negative impact from hedging, each cycle lasting on average just under 3 years. Depending on the start dates an unhedged portfolio would have produced an annualized impact ranging from 0.3% to -0.7% per year.
To me, the study suggests that if the future looks like the past, over the long-term, you may gain a little or lose a little due to currency fluctuations and I prefer the certainty of saving the cost. Your mileage may vary.
8 Canadian Capitalist // Jan 29, 2008 at 6:17 pm
Actually, here’s the Brandes study:
Link
I should note that the study I referred to is an earlier version. This is an update.
9 FinancialJungle // Jan 29, 2008 at 6:38 pm
Thank you for the link. I’ll review it when I get home tonight.
>>”from 1980 to 2005 there were nine cycles of positive and negative impact from hedging, each cycle lasting on average just under 3 years. ”
But are they really cycles or just noise? Take a look at this Canada/US exchange rate since 1970. Someone invested in 1970 had to wait 37 years to come a full circle. How many stock market cycles have we experienced during the same period? If I have 37 years, I’d rather bet on the stock market than currency.
http://research.stlouisfed.org/fred2/data/EXCAUS_Max_630_378.png
The above chart looks remarkably like an intraday TSX chart - it is that volatile.
Having said that, I’m not completely against leaving currency open. I like to travel outside of Canada too, so investing in some (but not too much) foreign currencies is just smart.
10 Canadian Capitalist // Jan 29, 2008 at 6:45 pm
Sorry, that Brandes study is slightly different from the one I referred to. It’s available here:
Link
11 John // Jan 29, 2008 at 8:17 pm
My approach is to simply view hedging as just one more thing to balance.
In this approach you own both hedged and non hedged versions of the same Index 50/50.
So if you aim for 20% total exposure to the S&P 500 in your portfolio just buy 10% hedged and 10% non- hedged.
You can use both I Shares and TD e Funds as part of the mix
US Stocks
XSP - 10%
TD902 -10%
International Stocks
XIN -10%
TDB911 - 10%
12 One Man Rodeo // Jan 29, 2008 at 9:35 pm
John, thanks for the excellent tip about spreading your allocations between the currency nuetral and the native currency funds. I will consider that and try to reasearch it.
I am brand new to investing and I constructed a td e-funds portfolio that has 25% of my portfolio in the US currency neutral and 25% in the International currency neutral funds.
My Thought was this: I’ve seen and expierenced effects of a$0.63 dollar and a $1.01 dollar in my everyday life, from employment to purchasing. I wanted to limited risk because my income is low (small factory worker) and I wanted some predictability of expected returns.
I didn’t know how to “predict” possible returns years from now unless there was hedging. I wanted to be conservative even though I am 31 because I have a lower middle class income and was prepared to pay the slightly higher MER for that hedging.
Some will that because I’m younger I should be more aggressive and play the currency cycles but on my income that would be uncomfortable.
Maybe John is onto something about splitting your foreign holding into native and currency neutral funds…?
13 Y HAT // Jan 29, 2008 at 11:02 pm
I use currency neutral funds in my portfolio and view the higher MER from holding a currency hedged fund as taking out a little insurance against a drop in the US dollar.
The US has huge budget and current account deficits, both of which have (and will continue) to put downward pressure on their dollar. Until these imbalances are worked out, I would consider it prudent to take out a little insurance against further drops in the greenback.
14 CheapCanuck // Feb 9, 2008 at 8:32 pm
Does anyone know if TD plans to expand their E-fund offerings? Looking specifically for an emerging markets fund with a (relatively) low MER. I want to have a 5-10% weighing of my asset allocation in emerging markets, and TDs current International Equity Fund doesn’t seem to have any of that exposure. I know I could add other funds to accomplish this, but the whole point of investing in the e-funds is to keep fees minimal, so if something is coming down the pipeline that would be ideal.
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