ETFs that hold foreign stocks or foreign stocks trading on US exchanges do not expose you to CAD/USD fluctuations (also, see Canadian Financial DIY’s post on this subject). I’ll explain why in this post with a simple example. Suppose you are interested in a Japanese ADR trading on the NYSE that is equal to one Japanese stock trading at 1,000 Yen on the Tokyo Stock Exchange. If the USD/Yen exchange rate is 1 USD = 100 Yen, all things being equal, the ADR will be trading at $10 US.
Now assume a Canadian investor buys that Japanese ADR and the CAD and USD are at par. So it costs $10 CAD for our Canadian investor.
Fast forward one year. Stock is still trading at 1,000 Yen but 1 USD = 90 Yen and 1 USD = 1.25 CAD. i.e. USD depreciated against the Yen but appreciated against the CAD. The ADR will trade at $11.11 US but it is worth $13.89 CAD.
So here’s how it works out for a Canadian investor:
Yen has appreciated 11% against the USD.
USD has appreciated 25% against the CAD.
Yen has appreciated 38.89% against the CAD.
For a Canadian investor the Japanese ADR appreciated by 38.89%, which is exactly the amount by which the Yen appreciated against the CAD. The reason is the CAD/USD fluctuation is overlaid on the USD/Yen fluctuation leaving a Canadian investor with just the CAD/Yen fluctuation.
In other words, the currency fluctuations a Canadian investor is exposed to for a foreign stock (or ETF) traded in an US exchange (that does not hedge its currency fluctuations) is not the CAD/USD rate. Instead, it is the CAD to whatever the currency the security is denominated in.
Let’s take a concrete example (thanks to Dave in Kanata for the numbers):
EFA($US) Jan. 2006 = 59.27; Jan. 2007 = 71.48
TD e-Series International Index ($CAD) Jan. 2006 = $11.30; Jan. 2007 = $13.76
1 $US to $CDN Jan. 2006 = 1.1629; Jan. 2007 = 1.1653
So, if I buy $CDN 100 of EFA in Jan 2006, I end up with 1.451 shares. In Jan 2007, my investment is worth $120.86. The same $100 will buy 8.8495 of the TD e-Series fund, which will be worth $121.76 one year later. Note that the returns on EFA and TD e-Series are almost identical for a Canadian investor.
Here’s some more examples:
EFA ($US) Jan. 2007 = $73.22; Jan. 2008 = $78.5; Up 7.2%.
1 $US to $CDN Jan. 2007 = $1.1649; Jan. 2008 = $0.9914; Down 14.9%.
EFA ($CDN) Jan. 2007 = $85.29; Jan. 2008 = $77.82; Down 8.8%.
TD e-Series International Index ($CDN) Jan. 2007 = $13.76; Jan. 2008 = $12.36; Down 10.2%.
EFA ($US) Jan. 2008 = $78.22; Jan. 2009 = $44.86; Down 42.6%.
1 $US to $CDN Jan. 2008 = $0.9927; Jan. 2009 = $1.2246; Up 23.3%.
EFA ($CDN) Jan. 2008 = $77.65; Jan. 2009 = $54.93; Down 29.2%.
TD e-Series International Index ($CDN) Jan. 2008 = $12.34; Jan. 2009 = $8.57; Down 30.6%.
Again, notice the similarity between the EFA returns in Canadian Dollars and that of the TD e-Series Fund.