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.

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.

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?

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.

@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.