Investors buy into currency-hedged funds on the premise that they can obtain returns provided by foreign stock markets while avoiding the deleterious effects of currency movements. The promise of currency-hedging is especially alluring in the case of US stocks because investors would like the good (quality US companies in dynamic sectors not available in the Canadian market) without the bad (everyone “knows” the US dollar is going down the toilet). Investors mistakenly believe that they can have the good and avoid the bad by investing in currency-hedged funds by paying a smidgen more in expenses and fees.

The reality, as I’ve pointed out in previous posts, is quite different: currency-hedging funds significantly lag the returns of foreign equity investors year after year. 2010 turned out to be no exception. The iShares S&P 500 (Currency-Hedged) ETF (TSX: XSP) returned 13.42% in 2010. But a US investor who owned the iShares S&P500 ETF (NYSE: IVV) earned 14.79% when measured in US dollars. Therefore, a currency-hedged Canadian Investor experienced a shortfall of 1.37%.

It’s true that the XSP investor outperformed the Canadian investor holding IVV directly (who would have earned 8.73%) in 2010 due to the appreciation of CAD against the USD. But if you take a slightly longer term view and consider the fact that XSP has trailed IVV returns in US dollars every year for the past five years, you’ll find that XSP’s outperformance is significantly eroded by the tracking error even with a significant appreciation in the Canadian dollar.

Let’s look at this with a concrete example. An investor purchasing $1,000 worth of XSP at the start of 2006 would have ended 2010 with $984. A Canadian investor purchasing $1,000 worth of IVV would have first converted her Canadian dollars into US dollars. At the start of 2006, she would have invested $857 (US) in IVV, which at the end of 2010 would be worth $958 (US) or $952. The C$ has appreciated 17% in five years but the XSP investor is ahead of the IVV investor by only 3.3%.

As in previous years, the observation that currency-hedged funds trail the returns of US dollar denominated funds extends to the TD e-Series Funds. The TD e-Series US Index Currency Neutral Fund (Fund Code: TDB904) also trailed the US dollar returns of the TD e-Series US Index US$ (Fund Code: TDB952) by 1.65% in 2010.

This article has 10 comments

  1. You certainly have me convinced of the benefits of not hedging when on a US market ETF. What about other ETF’s, such as the Emerging Markets, or EAFE ETFs. In those cases are they hedged to the Canadian dollar as well? And if so, is the Cdn dollar hedged against all world currencies or against the US dollar because that is how the stocks in the funds are bought? And if so, do the Cdn. dollar hedged ishares funds lag their US counterparts? Is it worth buying the US product in US dollars?

    Thanks for a helpful and well written blog.

    Peter Sakuls

  2. Great post, CC. I find it hard to justify currency hedging for any period longer than a few years and recently revised my site’s model portfolios to get rid of it once and for all.

  3. well done cc – a great service to your readers

  4. You didn’t mention the reason why? Could it be because the cost associated with hedging outweighs any benefits from the hedging strategy? A friend of mine who is the CEO of a junior mining company told me that he never hedges for that precise reason – too expensive.

  5. @Peter Sakuls: IMO, currency hedging makes even less sense for foreign developed markets and emerging markets. The reason is that the exposure for a Canadian investor is not to one currency but to a basket of currencies, which reduces currency risk substantially. Example: Canadian dollar might appreciate against the Pound but depreciate against the Yen etc.

    Note that a Canadian investor buying a foreign stock market ETF in the US is not exposed to the fluctuations in the CAD/USD. See this post:

    http://www.canadiancapitalist.com/currency-effects-of-buying-foreign-stocks-or-etfs-on-us-exchanges/

    @Canadian Couch Potato: I agree. Especially considering the empirical evidence in Triumph of the Optimists that it is better to hold unhedged portfolios.

    @Rob: Thanks for your comment,

    @Phil S: The biggest culprit cited by Raymond Kerzérho of PWL Capital is Residual Currency Effects. The tendency of US stock prices and US dollar to move in opposite directions. I wrote about it here. The post has a link to Mr. Kerzerho’s paper:

    http://www.canadiancapitalist.com/why-currency-hedged-funds-have-large-tracking-errors/

    Note that

  6. Pingback: Tweets that mention Currency-Hedged Funds Underperformed in 2010 | Canadian Capitalist -- Topsy.com

  7. Say I want to invest in Japanese Index Fund. Knowing that Yen is incredibly ‘strong’ right now. Does it make sense to invest in a currency hedged fund?

    I get that for long term investors, currency hedging only adds extra cost with no benefits.

    But when it is appropriate to use currency hedged fund?

  8. @David: Good question. I don’t think so. Investors in broad-market indexes should be buying and holding for the long-term. The long holding periods should rule out currency-hedged funds.

  9. Pingback: Weekly Review-Welcome Back!

  10. Pingback: Canadian Personal Finance & Investing Carnival