In the past couple of updates on the performance of currency-neutral funds, we found that these funds do not quite live up to the expectation of removing the effects of currency fluctuations for a modest cost. Instead the currency-neutral funds show a performance lag ranging from 2.33% for the iShares S&P 500 CAD-Hedged ETF (TSX: XSP) to 1.30% for the iShares MSCI EAFE CAD-Hedged ETF (TSX: XIN) (See posts Performance of Currency-Neutral S&P 500 Index Funds and Performance of Currency-Neutral MSCI EAFE Index Fund).

Reader Cal wondered how the lag would affect an investor who wants to invest $10,000 in US stocks and has the option of simply picking XSP versus converting to US dollars, buying IVV and after 25 years converting back to Canadian dollars. Since there are a number of variables, I constructed a spreadsheet to play around with the following variables:

– the term of investment (in years)
– annual returns
– Currency-hedged fund tracking error
– Currency conversion cost
– size of currency appreciation / depreciation over the investment term

For a 25 year term, annual returns of 7%, currency-hedging lag of 1.5%, one-way currency conversion cost of 1.5%, we find that (no surprises here) not hedging is advantageous if the foreign currency appreciates or remains the same against the Canadian dollar.

Under these assumptions, due to the large annual performance lag of currency-hedged funds, currency hedging turns out to be unprofitable even when the foreign currency depreciates by 25%. It is only when the foreign currency depreciates by 30% or more that the currency hedged fund comes out ahead. If the depreciation is 50%, the currency hedged fund has an advantage of 31% over its unhedged counterpart.

The spreadsheet will allow you to play around with the variables. For instance, if you use Norbert Gambit to convert currency, your costs might be as low as 0.2%. And if the performance lag of the currency hedged fund is 2% then not hedging is advantageous even at a depreciation of 35%.

The spreadsheet is available here.

This article has 8 comments

  1. CC: do you think this effect wouldn’t play out as wildly with institutional holdings? I’m thinking of my pension fund which old the foreign assets directly and hedges the foreign currency risk. No tracking error since it’s not an index, does this ‘lag’ become less of an issue?

  2. I guess the upshot is that currency hedging really only has a hope of providing a benefit when CAD is deeply and obviously undervalued, such as the late 90s when the CAD:USD was 0.65. Today that is much less obvious. I could imagine a scenario where CAD appreciated another 25%, but I don’t think it is likely or inevitable.

  3. @Jon D.: PWL Capital pointed out in a report that institutional investors employ the same hedging strategies that retail funds do and so they will face the same issues with lag. My understanding is that institutions hedge about 1/2 (?) their foreign currency exposure. Perhaps they are worried about a significant devaluation of the foreign currency and are willing to bear the cost??

    @Andrew F: And the irony is that currency neutral funds were very rare when the C$ was scraping bottom. Back then retail investors were clamoring for direct US exposure because the C$ depreciation had magnified the US stock out performance even more!

  4. I am sure that most investors would use some sort of currency conversion to keep costs at least under 1% (DLR.TO/DLR-U.TO), but it really does seem to be a play on the dollar doesn’t it. The spreadsheet shows potential for a decent swing, depending upon how the dollar does.

    Thanks for doing the spreadsheet, much appreciated.

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  8. One thing about the depreciation of the foreign currency that has to be considered is whether the companies that you invest in will appreciate by an equivalent amount to offset the difference. After all, why should the earnings of most large multinational corporations be dependent on the currency of the country they are headquartered in.

    i.e. American currency depreciates 30% to be worth $0.70 Cdn. Now KO will subsequently be equivalently valued in Cdn dollar terms so if KO was worth $100 Cdn at the start and $100 US at the start and its value did not change at the end it should be worth $100 Cdn or $142 US.

    I think this is essentially true if you are talking about a currency change that has occurred over a long time period such as 25 years although it may not be true of a more rapid currency change over say 2-3 years.