Archive for October, 2010

This and That: Premium hikes, battered investors and more…

October 28, 2010


In light of the market crash of Fall 2008, does diversification still make sense? In this video excerpt, Harry Markowitz explains the even in the market crash, different asset classes did behave as one would have expected them to:

I’m unable to highlight all the articles worth checking out in my weekly round up but you can check them out through my Twitter feed. I try and keep my tweets to an average of not more than 5 per weekday.

Happy Halloween everyone! Have a great weekend!

Why currency-hedged funds have large tracking errors

October 26, 2010


In past posts, I’ve pointed out that currency-hedged funds such as the iShares S&P 500 (CAD-Hedged) ETF (XSP) and TD US Index Currency Neutral e-Series Fund (TDB904) exhibit large tracking errors that cannot be explained by their higher MER alone. I’ve never had a good explanation for why is so. And more importantly, I couldn’t answer with conviction whether large tracking errors are simply a statistical anamoly or whether negative tracking errors are likely to persist in the future. A recent paper by Raymond Kerzérho of PWL Capital (thanks to Larry MacDonald for pointing to this in a recent post) titled Currency-Hedged S&P500 Funds: The Unsuspected Challenges provides a conclusive answer to both these questions.

[Tracking Errors in Currency-Hedged Funds Larger than MERs]

The paper breaks down tracking error into four components: (1) Difference in management fees (2) Transaction costs such as commissions, bid-ask spreads and other administrative costs (3) Interest-rate differential between Canadian and US exchange rates and (4) Residual-Currency Effects (RCE).

The last of these — RCE — is the most interesting because it accounts for the bulk of the observed tracking errors. RCE results from fluctuations in stock prices. Here’s one example from the report: A S&P 500 currency-hedged index fund with $100 million in assets starts off with a $100 long position in the S&P 500 index and a $100 million short position in US dollar forward contracts (all US dollars). If the S&P500 index advances 3%, the fund will be long $103 million in the S&P 500 but the forward contracts cover only $100 million. The fund is underhedged by $3 million. If the US dollar falls by 3% during the same time period, the fund will have a tracking error of +0.09%. If the US dollar increases by 3%, the fund will have a tracking error of -0.09% (the fund outperforms the index).

RCE will give rise to a positive tracking error (fund underperforms the index) when stocks and currency moves in opposite directions and negative tracking error (fund outperforms the index) when stocks and currency moves in the same direction. If stock prices and currencies move randomly with respect to each other, you would expect currency-hedged funds to underperform at certain time periods and outperform in other time periods (reader Avon Barksdale made this point in Why Currency Hedging is Necessary).

It turns out currency and equities more often than not move in opposing directions. This won’t be a surprise to investors who have watched US equities zig when the US dollar zags and vice-versa in the recent past. But this observation is not limited to the 2006-09 time period. Mr. Kerzérho estimates that the -0.38 correlation between the S&P500 and US dollar in the 1980 to 2009 period would have resulted in a RCE hit of 0.40% per annum for a currency-hedged portfolio. In fact, Mr. Kerzérho found that 60-month rolling correlation between US stocks and the US dollar never moved into positive territory in the 1980 to 2009 period. Such a long history suggests that the 2006-09 period isn’t simply an anomaly. Mr. Kerzérho concludes [emphasis his]:

Based on this evidence, I believe that a negative correlation is likely to persist rather than revert towards zero, and that this therefore imposes a large inefficiency cost on the unitholders of S&P500 currency-neutral funds.

How to avoid currency conversions on US Dividends

October 25, 2010


You learn something new every day. A reader commenting on the Canadian Couch Potato blog here revealed two possible ways on avoiding currency conversion on US dollar dividends received in a self-directed RRSP account. The first of these methods works at TD Waterhouse (my review here), where the reader holds his accounts but it should be applicable at any broker who washes trades by setting the buy and sell exchange rates to the same value.

Note that unless you have a substantial sum invested in US-listed ETFs, you won’t save all that much by avoiding currency conversions on dividend payments. For example, the Vanguard Total Market Index Fund (VTI) has a dividend yield of 2%. If you have $100,000 invested in VTI, your annual dividends will be $2,000. Assuming currency conversion charges run the typical 1.5% each way, avoiding these conversions entirely will save you between $30 and $60 annually.

Enroll in a Synthetic DRiP

Unfortunately, an investor enrolling in a synthetic DRiP would incur double the currency conversion charges. See this post for details.

Synthetic Dividend Reinvestment Plans (DRiPs) offered by many discount brokers allow investors to reinvest dividend payments into whole shares of a stock or ETF. It turns out that when you sign up for a DRiP offered on a US-listed stock or ETF, any dividend payments are held in US dollars and used to purchase whole shares of the stock or ETF. The exchange rate on the US dividends and the stock purchase are set to the same value, effectively eliminating USD-CAD conversions.

Wash dividends into a US Dollar Money Market Fund

Unfortunately the author is unable to confirm that TD Waterhouse clients are able to avoid forced foreign exchange conversions. The author was clearly told by client service representatives that washing US Dollar dividends is not possible.

The reader said that TD Waterhouse offers a second method of avoiding foreign exchange conversions on dividends received from US-listed ETFs. A client can call one day prior to the dividend payment and wash the US dollar dividends into TDB166. However, a quick call to TD Waterhouse revealed that the broker will not wash dividend payments into the US Dollar Money Market account. That’s a shame. As an investor who prefers to accumulate dividends in cash and reinvest it in an asset class that is below target, I would have liked to employ this method and avoided the forced currency conversion.