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.

This article has 18 comments

  1. I’m not an economist nor am I a currency trader and I don’t want to pretend like I know what currencies are going to do in the short and medium terms… And as much as we like to complain about our governments handing out billions of loonies in bailouts to the auto companies… It is really a drop in the bucket compared to what the US government has been shelling out to save their banking & automotive sectors. The TRILLIONS that they’ve been shelling out can’t possibly be good for their currency and conventional wisdom would think that it may come home to roost at some point down the road. I believe that we are in unprecedented times and we have no historical guide as to what is going to happen, but in my opinion, it can’t possibly be good. So, the big question is – what is going to happen to Canada when our biggest trading partner gets slaughtered by whatever the unknown future problem turns out to be? Heck if I know. Is it better to be in Canadian or US dollars when this happens? Heck if I know. Will precious metals or other commodity prices hold up? Heck if I know.

    • Canadian Capitalist

      I don’t know either. But it seems to be a common confusion that ETF that trade on US exchanges that hold European, Japanese and other foreign stocks are affected by the CAD/USD fluctuations. They are not. They are, instead, affected by the fluctuation of the CAD with whatever local currency the stocks are trading in.

      If the USD does go down the tubes, would the Bank of Canada stand idly by and watch the CAD appreciate tremendously vis-a-vis the greenback. I don’t think they will.

      Also, it seems unfathomable now, but could the CAD go down the tubes? It could. When Quebec separatism was a huge threat, the CAD was affected negatively. Who knows what the future will bring?

  2. Thanks for the interesting post.

    In the example shown, the CAD/USD exchange rate is almost identical at the beginning and at the end.

    A more illustrative example might be to look at the effect of holding these two investments (EFA and the TD e-Series Fund) over a period where the CAD/USD exchange rate is much different before and after. This would illustrate how large CAD/USD fluctuations don’t affect the returns from international holdings held in USD or CAD denominated funds.

  3. Canadian Capitalist

    Geron: I’ve updated the post with two more examples. In one instance, the CAD was up sharply and down sharply in the next. The EFA returns tracks that of the TD e-Series International Fund in both (not perfectly but that could be due to any number of factors but over time, close enough). Thanks for the idea.

  4. Thanks for the link and great follow up post especially the last two examples in which the funds moved down regardless of whether the USD moved up or down vs CAD. I wonder if the difference between the e-Series and EFA gets bigger the more violent are the currency swings. From your examples, it was 0.7% in the stable 2006-07 year but 1.4% each year in volatile 2007-09 … and EFA performed better.

    • Canadian Capitalist

      @CanadianInvestor: I wouldn’t read too much into the slight differences in yearly returns. TD e-Series is a mutual fund and as such is valued precisely at the NAV based on the closing prices of its holdings in exchanges in Europe, Japan etc. EFA trades on the NYSE and its trading price could vary significantly from the NAV because foreign markets are closed and EFA is still trading. According to iShares, EFA’s premium/discount to NAV has varied between 8.61% to -7.35% in the last quarter of 2008. So, in comparing the ETF to a mutual fund, I’m looking for approximately close annual returns. I don’t expect them to be perfectly aligned.

      Of course, for long-term investors, these fluctuations are mere noise. The 2007, 2008 differences may be high simply because markets were more volatile in that period. It’s just a guess though.

  5. I tried to look at it from a little bit different perspective. Basically I tried to prove that at any given point the exchange rate between CAD and other than the US currency (I tried Taiwanese dollars and Hong Kong dolllars) is the same as converting to the US dollars first and then to the other currency.

    I took the data from Yahoo Finance as of June 1, 2009:

    CADUSD 0.92
    CADTWD 29.66
    CADHKG 7.12

    USDTWD 32.31
    USDHKG 7.75

    1 CAD -> 0.92 USD -> 29.73 TWD (difference 0.07 TWD)

    1 CAD -> 0.92 USD -> 7.13 HKG ( difference 0.01 HKG)

    So it shouldn’t matter what happens with the currency “in the middle” (USD in this case), the exchange rate between CAD and the “other” is what actually matters.

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  8. Good article clearing up a common misconception.

    I would add two reasons why holding international assets (ETFs) in a US dollar denominated account makes a lot of sense

    1) Access to very low MER exchange traded funds (ie. Vanguard).

    2) The CAD/ USD exchange rate has tended to move in synchronization with the markets (an up market day is almost always an up day for the Canadian dollar). If you can separate the day you sell an equity, from the day you repatriate into Canadian dollars you can often squeeze out an additional 2 or 3% return.

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  10. You know, this is the only place anywhere that I’ve ever seen this attempt to be explained…. and I have done some reading…. I follow your own example, i.e., the first half of the article, but Dave’s examples are a bit confusing – I’ll have to read those again.

    Basically I can see how your own example is correct, but that was in a case where both the Yen and the USD went up against the loonie, so it had a “good” currency effect, so to speak. If the Yen were to drop severely I think it would still have a negative impact on the Canadian’s return/value.

    But this is a really important question I’ve been wondering about, ie., in relation to the US dollar. For thought experiment purposes, say I own Honda ADRs in US dollars and the dollars are becoming severely inflated, so that they fall sharply in relation to the Yen (let’s say). How does this play out on the Canadian end if the greenback has also fallen against the loonie?

  11. Ha – I guess I should also read all of the other comments – all I wish is that Canada would start to decouple more of its trading from the US – we need to diversify our trading partners. It’s silly to be so tied to one and subject to most of its troubles.

  12. I was just reading about the Claymore CWO Emerging Markets ETF which hedges the US/CAD, but leaves investers exposed to the exchange risk between the various emerging markets and the US$.
    I know very little about exchange risk but based on the above entries, does this not mean CDN investors are actually at a greater exchange risk by this strategy?

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