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moneysense.ca, 6/01/10
Currency-neutral S&P 500 Fund Versus S&P 500 Returns in CAD
Current issue:
The recent post on the performance of currency-neutral S&P 500 funds seems to have confused a lot of readers. One commenter pointed out that what matters to Canadian investors is the performance of a currency-neutral fund such as XSP compared to the returns in Canadian dollars of a direct holding in a fund like IVV, not dry discussions of tracking error. So, let’s compare the performance of the iShares CDN S&P 500 Hedged to Canadian Dollars ETF (TSX: XSP) with the returns of iShares S&P 500 Index Fund (NYSE Arca: IVV) for the 2006 to 2009 time period for a Canadian investor. A minor point of clarification: XSP’s inception date is 2001 but I’m picking 2006 as the starting year because in late 2005 XSP changed its mandate from a clone fund (a fund that used derivatives to track the S&P 500 to skirt RRSP foreign content rules that were in force prior to 2005) to a currency-neutral fund.
First, let’s look at how the Canadian dollar performed against the US dollar in the 2006 to 2009 time period. The US dollar was worth C$1.17 at the start of 2006 and ended 2009 with a value of $1.05, which works out to a depreciation of 10.2%. If a Canadian investor purchased a stock trading in the US in 2006 and held it to the end of 2009 and if the stock price remained exactly the same, she would have lost 10.2% in Canadian dollar terms solely due to the depreciation of the US dollar against the loonie.
An investor who had invested $100 (US) in IVV at the start of 2006 would have ended up with $97.5 (US) at the end of 2009 (assuming dividends were reinvested). In US dollar terms, the return works out to a total loss of 2.5%. Canadian investors would have fared worse because it would have cost us C$117 to buy $100 (US) worth of IVV in 2006. At the end of 2009, $97.50 (US) would be worth C$102.38 for a loss of 12.5% in IVV for Canadian investors.
Recall that investors are under the impression that XSP will deliver the returns of IVV in USD for an extra cost of just 15 basis points because the USD exposure is hedged. That is, investors would have expected XSP to also show a loss of roughly 3.0% in the 2006 to 2009 time period. In reality though, XSP lost 13.7% in the 2006-2009 time period, which is more than the loss experienced by a Canadian investor who directly invested in the S&P 500 and did not hedge the currency fluctuations even though the US dollar depreciated 10.2% that period.
moneysense.ca, 6/01/10
So, if the opposite trend occurs – USD appreciation vs. CAD – would an XSP investor fare better than those investing directly in the US fund?
@MikeH: No. The XSP investor would fare even worse than a Canadian investor holding IVV because:
(1) IVV investor received a boost from USD appreciation.
(2) XSP investor paid the price for hedging through tracking error.
2008 provides a nice illustration of what happens when the USD appreciates. IVV lost -23.3% in CAD but XSP lost -40.14%. That’s because IVV lost -36.6% in USD and the USD appreciated against the loonie.
In tomorrow’s post, I look at XIN which shows what happens if the opposite trend occurs over the same time period.
Very interesting post. Given that by hedging you are essentially paying for insurance to cover for unknowable future currency movement, I had previously decided against using currency hedged funds. It always seemed to me to be logically inconsistent to want to invest in the US economy, while at the same time wanting to buy insurance against the poor performance of a fundamental of that same economy. If I think the US$ is going down, my money will simply be placed elsewhere.
Nonetheless, given the complete failure of the hedge here, it seems to me that iShares has some explaining to do on this one!
CC this post is interesting in that ilustrates the performance of this particular hedged fund and that we should do due diligence. However, currency hedging is not an exotic tool and is used all the time.
I’m not clear and haven’t seen comments that explain the true reason for underperformance:
1) Is it error in tracking and/or hedging costs that nullified hedging effect?
2) Is it that hedging was not properly implemented?
3) Other?
Any thought?
@Andy: I agree though I didn’t think that the tracking errors would be as wide as they are here. I’m pretty sure iShares does a good job of hedging; it’s just that it is messy and tracking errors are inevitable.
@Basil2: I can think of three reasons (subject of a future post) on why tracking errors are so wide:
(1) Cost of hedging: I read somewhere is that the all-in costs of hedging would average about 1% per year. Someone who is an expert can weigh in on the all-in costs of hedging currency positions.
(2) Withholding tax: In a RRSP, an ETF such as XSP that holds a US-listed ETF will be subject to a 15% withholding tax. A Canadian resident holding IVV in her retirement account doesn’t pay any withholding tax. Assuming a 2% dividend yield, the withholding tax costs about 0.30%.
(3) Higher MERs. XSP charges 0.15% to provide a currency hedge.
All these effects add up to a 1.5% per year tracking error. I don’t know why the observed tracking error is twice as much.
@Canadian Capitalist: As has been discussed in other forums, over the time period of your analysis, a good deal of the movement (and boy was there movement) in the value of the S&P500 was inversely proportional to movements in the US$. This held right down to the level of daily fluctuations.
I have seen it suggested that one way to look at these movements in the S&P500 was to consider the value of the S&P as correcting itself for a changes in the value of the dollar. Hedging against this very close inverse relationship was likely both unusually expensive and prone to tracking error.
CC it’d worthwhile to check a few more funds and longer time periods. I’d be curious to see if findings are sistemic or only limited to this case.
@Basil2: We simply don’t have data for a longer time period. Currency-neutral funds were first introduced in late 2005, so we just have a 4-year history. Most currency-neutral ETFs are very recent, so when we do have a bit of meaningful history to look at, I’ll do so. To my knowledge, XSP and XIN have the longest history. I’m going to post XIN’s performance in the near future but I found that XIN also showed a significant tracking error.
I agree that the history is too short to make a definitive statement but the results so far confirms my initial suspicion that tracking errors are likely to be in the 1.5% range.
I wonder if anyone has thoughts about using forex to put up a crude hedge against currency risk for a fairly low cost.
For example, suppose you have $10,000 US to invest. You can sell 10000$ worth USD/CAD for around $300 (at least with Questrade’s forex margin requirements of 3%). I haven’t done fx trading at all, but are there any other costs involved in holding that besides the 2 pip spread, which is negligable? Even if you have to come up with the $300 on margin, questrade’s current margin rates are 1.5% which works out to only $4.50 per year, 0r 0.045% of the initial investment.
I admit I haven’t done a lot of number running, and this is just some rough figures I threw together. Am I missing something?
@CC: I would also suggest that the tracking error could also be due to bad timing. Since hedging is essentially an insurance product based upon rolling the dice and hoping for the best you could also be experiencing the effect of active hedging. The cost of hedging might be 1%, the true cost could be quite a bit higher when you consider bad timing.
Example:
You hedge against a falling US$ for a 3 month period. During this time the US$ goes the wrong way. Now you have hedging costs plus the currency change to factor in.
Hedging could be compared to short selling I guess. You make an agreement with another party to sell them X amount of currency at Y rate on such and such a day. If you guessed right then money is to be had, if you didn’t then oops, loss.
Essentially this means that a hedged product has its place as an investment tool, much like double and triple leveraged ETFs. You can make bunches of money using them, or you can loose your shirt and the kitchen sink as well. If you are a buy and hold person you will pretty much loose every time you get into a product with more than 1 feature.
My comment may be off topic (pardon me) but I am thinking that Canadian economy is so link to US that investing in US may not provide us diversification as we are expecting. TSX is energy/commodity based index, if US is doing well aren’t we will reap the reward or vice versa? Then there are other issues like foreigh exchange, withholding taxes, loss of divident tax credit. Aren’t we better of to invest in Canada ? or finding an asset class in US which is not correlated well with US Stocks for example US Bonds ? I think at best one should treat US as part of its internation portfolio where US is no more than 2 to 3% of portfolio. US Currency will be one of the many currencies. This approach would not require any hedging as ,hopefully, different currencies will cancel out each other. Any thoughts are welcome
Thanks, CC. I think I was the one you refer to in the header of your post.
This result is concerning.
On an institutional investor level, the pure transactional cost of currency hedging is extremely low – below 0.2% per annum, possibly below 0.1% (i.e. covered by the incremental MER). So if the funds’ actual currency hedging costs were anywhere near 1% I would be quite surprised.
I suspect more likely the issue is one of timing and hedge duration. Typically these things are done with rolling hedges e.g. (making this up) hedge 1/4 of the exposure each quarter for one year, roll it over to a new hedge when the existing hedge expires. This (and all other hedging vehicles) never actually neutralize currency exposure completely. They just smooth out volatility and delay the transmission of currency shifts by the duration of the hedge. So e.g. if you the investor has a 5 year horizon and the fund hedges by 1 year rolling hedges you are actually only partially protected (and may end up on the wrong side of an implicit bet!)
This is a good warning signal for me to look into this further. While I know some of this stuff on a corporate level, I’ve been insufficiently careful thinking it through for my own investments. I’ve been considering shifting over my indexed ETF US equity holdings in my Smith Manoeuvre portfolio to these hedged funds. The rationale – which is valid – has been that my mortgage liability supporting the Smith Manoeuvre is in Cdn$ so I should try to minimize my net forex exposure in the matched investment assets – sound principles of asset -liability matching. But I neglected the timing issue.
Note I don’t know if the hedging is by 1 year rolling hedges. That’s a wild guess.
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