Archive for May, 2008

The Costs of Currency Hedging: Taxes

May 11, 2008

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In an earlier post, we discussed how investing in funds that hedge the exposure to foreign currencies entails a significant cost in terms of a large tracking error. There is a further cost involved in holding these funds: taxes. It is no surprise that currency-neutral funds could generate large taxable distributions – by their very nature, currency contracts are short-term instruments that trigger a taxable event at the time of settlement.

For instance, 11.9% and 37.0% of the returns of the iShares S&P 500 Index Fund (IVV) were in the form of dividends and hence taxable in 2006 and 2007 respectively. In contrast, the iShares CDN S&P 500 Index Fund (XSP) generated taxable distributions of 11.2% and 434% of the returns during the same time period without accounting for the 15% withholding tax on the dividends from its holdings in IVV. The story is similar in the case of iShares MSCI EAFE Index Fund (EFA) (10.0% and 27.5% in taxable dividends in 2006 and 2007) and iShares CDN MSCI EAFE Index Fund (XIN) (12.8% and 238.68% in taxable distributions in 2006 and 2007).

The tax inefficient nature of currency-neutral funds implies that they should be held in tax-deferred accounts. Historically, the currency-neutral funds used to be called “clone” funds that used derivatives to skirt around foreign content restrictions in RRSPs. But even when held in RRSP accounts, these funds have a tax disadvantage – while dividends received from IVV are not taxed, a withholding tax of 15% is paid by XSP on dividends received from IVV. To my knowledge, a Canadian investor holding a currency-neutral fund in a RRSP account cannot recover the withholding tax, which adds another 0.3% (15% of a 2% dividend yield) to the expense of holding these funds.

This and That

May 8, 2008

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The Globe and Mail is asking readers to vote for their favourite blogs. If you haven’t done so already, you can vote for your picks here.

  1. This Sunday is Mother’s Day. Unlike a column in the Ottawa Citizen today that suggested organic cleaning supplies (which Mom wouldn’t appreciate that?) Mike from Quest for Four Pillars suggests some frugal gift ideas that Mom would really like.
  2. CIBC economist Benjamin Tal noted in a research report that investors are reacting to market volatility by sitting on a pile of cash.
  3. Globe and Mail readers responded by shooting the messenger. Rob Carrick wrote in his column that it is up to investors to take advantage of market declines.
  4. Tom Bradley of Steady Hand gives investors a reality check: we are in a low-return environment for equities, not “8 to 10 percent with zero downside”.
  5. Gail Vaz-Oxlade, the no-nonsense host of Til Debt Do Us Part, explains her brilliant jar system of budgeting.
  6. Growth in Value is suspicious of new financial products but applauds Scotia Bank should for the Bank the Rest campaign, which enables debit card holders to round up their purchases and deposit the extra money into a high-interest savings account.
  7. Preet of Where Does All My Money Go is giving away a copy of KPMG’s Tax Planning for You and Your Family. All you need to do for an entry is leave a comment here.
  8. Canadian Financial Stuff debated the pros and cons of having kids paying for their education.
  9. Red Flag Deals featured a comprehensive article on the Tax-Free Savings Account.
  10. The Personal Finance Check-Up list from Thicken My Wallet blog.

Have a nice weekend everyone. And Happy Mother’s Day to all the Moms out there.

The Costs of Currency Hedging

May 7, 2008

44 comments

With the steep increase in the value of our dollar compared to other currencies, hedging against currency fluctuations has become popular and many US and international equity funds are now available in currency-neutral flavours. There are two schools of thought on currency hedging: one holds that currency fluctuations “cancel out” for a long-term investor and the other holds that currency fluctuations have a significant effect on equity performance and should be hedged away. Even if you are convinced of the need for hedging the currency exposure, there is one reason for thinking twice about hedging: cost.

Let’s take the iShares CDN S&P 500 Index Fund (XSP), which holds the iShares S&P 500 Index (IVV) and hedges the exposure to US dollars for an extra MER of 0.15%. At first glance, it seems to be a small price to pay for hedging. However, the extra MER doesn’t seem to be the only overhead for hedging. The total cost of the hedging shows up in the tracking error. IVV posted a total return of 15.78% and 5.3% in 2006 and 2007 respectively compared to the total return from XSP of 14.06% and 3.01%. In other words, XSP trailed IVV’s return in US dollars by 1.72% and 2.29% in 2006 and 2007.

Another example is the difference is performance between the TD US Index (US$) e-Series Fund (TDB952) and the TD US Index Currency Neutral (TDB904). The currency neutral version charges an extra MER of 0.15% but the tracking error was 1.8% in 2007 and 1.1% in 2006. Since the benefits of hedging are debatable but the costs are certain, it may be best to stick with direct exposure to foreign equity markets.

Updated October 26, 2010:
Both XSP and TDB904 again trailed their US dollar counterparts in 2008. Details in this post:
Currency-Hedged Funds Performed Poorly Again in 2008

The currency-hedged EAFE Index Fund (XIN) also exhibits large tracking errors: Performance of the Currency-Neutral MSCI EAFE Index Fund