As I pointed out in my previous post, equity markets around the world lost quite a bit of value in the third quarter of 2011. However, the Canadian dollar also posted a significant loss against the US dollar and Japanese Yen and remained more or less flat against the Euro and the Pound. As a result, portfolios that held international stocks without hedging away the currency risk did not lose as much as portfolios that employed currency hedging. This is not a new phenomenon.

In a recent post (See Vanguard Canada initial ETF offering falling short), PWL Capital’s Justin Bender took a look at the risk and return characteristics of two balanced portfolios with significant foreign stock holdings. Both portfolios allocated 30% to the iShares S&P/TSX Capped Composite ETF (XIC) and 40% to the iShares DEX Universe Bond ETF (XBB) to gain exposure to Canadian stocks and bonds respectively. One portfolio allocated 15% each to two currency hedged ETFs: iShares S&P 500 CAD-Hedged ETF (XSP) and iShares MSCI EAFE CAD-Hedged ETF (XIN). The other portfolio allocated 15% each to iShares S&P 500 ETF (IVV) and iShares MSCI EAFE ETF (EFA).

Mr. Bender found that between December 2005 and August 2011, the CAD-hedged portfolio posted slightly lower returns than the currency-unhedged portfolio (3.75% versus 3.81%). Interestingly, the Canadian dollar was valued at USD 0.8557 in December 2005 and at USD 1.0221 in August 2011. In other words, the currency-hedged portfolio underperformed the unhedged portfolio even though the Canadian dollar appreciated 19% against the US dollar. During the same time period, the Canadian dollar lost 3% against the Euro, lost 24% against the Yen and gained 27% against the Pound Sterling.

The currency unhedged portfolio was also much less volatile. The Standard Deviation of the unhedged portfolio was 7.9%, significantly less than the 9.3% SD of the CAD-hedged portfolio. A graph of the 3-year rolling SD shows that the CAD-hedged portfolio is consistently more volatile.

3-year Rolling SD of Currency Hedged versus Unhedged Portfolios. Source: PWL Capital

ETF vendors should take note of these findings and instead of launching even more CAD-Hedged ETFs, they should be focusing on providing investors with more (and better) choice in the form of broad market ETFs that directly hold foreign stocks or ETFs.

This article has 17 comments

  1. *Why* did the currency-hedged portfolio underperform if the Canadian dollar appreciated 19%? Maybe it’s late and I’m missing something obvious, but what is going on? How does it work?

  2. Given that VEA is denominated in US dollars, but actually reflects a basket of other currencies does that mean that if the US dollar went up by 10% against the weighted basket of foreign currencies in VEA then the ETF share price should drop by 10% (assuming no change in the underlying value of the foreign holdings) ?

    If my assumption is correct then the yuan must be pulling up the weighted value of the foreign currencies relative to the US dollar because when I plot VEA and VTI against each other on google finance they tend to be highly correlated at the moment and over the last month do not show a drop one might expect due to the appreciation of the US dollar due to the flight to safety phenomenon that has occurred.

    Any thoughts ?

  3. @Viscount: A big reason is the terrible tracking errors of the CAD-hedged ETFs. I wrote about it in the past:

    Another PWL Capital research report explained why tracking errors are so large for CAD-Hedged funds. They found the culprit to be residual currency effects. i.e. tendency of currency to move in opposite direction to equities.

    @RJ: Did you mean the Japanese Yen? The yen was more or less flat against the USD but the Pound Sterling and Euro dropped in value in the past month. In general, in times of market turmoil, risky assets are highly correlated.

    If you take a slightly longer view, there is divergence between S&P500 and MSCI EAFE index. In the previous quarter S&P 500 dropped 14.3% compared to a 19.60% drop for the MSCI EAFE in US dollars.

  4. the popularity of currency hedging in the past 10 years simply reflects performance chasing of the currency – there is nothing ‘passive’ about this – it is active management, but at its worst

    hedging is like house insurance – a great deal when your house is on fire and costly when it isn’t

    you never heard of retail investors hedging when the CDN dollar was at $0.67US, but when it is $1.05US, people can’t get enough of it

    investor’s behaviour will never change –

    good post cc

  5. All true… but it’s kind of annoying sometimes when you can’t get a good discount because declines in foreign stocks are offset by declines in the canadian dollar 🙂

  6. Great post. This reinforces my strategy CC, non-hedging my ETFs.

    I like what Rob had to say, re: hedging is like house insurance. Well said Rob.

  7. CC,

    In the absence of many Canadian ETFs offering direct currency exposure by holding foreign stocks how would you best advise a smaller Canadian investor to avoid the currency conversion difficulties. In your example of the CAD-hedged portfolio posting slightly lower returns did that include possible currency conversion fees for the unhedged portfolio?

    The reason I ask is that one of the main principles of index investing is to keep costs low. However, if you are paying 2% conversion fees everytime you purchase IVV or EFA then does that not affect your decision of whether to hedge or not?


  8. @Rob: To twist your metaphor a little bit, it appears that when it comes to currency hedging, the cost of those premiums do not seem to ever cover the cost of the house burning down. Therefore, one may be better off self insuring.

    I also agree with you that when the C$ was scraping bottom, there was very little interest in currency hedging. Instead, investors were demanding RRSP foreign content rules should be eliminated so that they can take advantage of (a) higher returns from US stocks and (b) an extra boost from the strong US dollar. We’ve come full circle now.

    @Value Indexer: But the offset is not 100%. Typically stocks fall more than the dollar and also gain more than the dollar. So one may not be getting a really good discount but one is not overpaying either. Of course, an investor could buy US dollars when our dollar is high and US stocks after they drop but this involves so many timing issues to be impractical.

    @Daniel: There are two negatives with holding US ETFs directly. (1) High cost of retail foreign currency conversions and (2) US Estate tax issues. An investor can overcome (1) through the Norbert Gambit but (2) is a huge issue IMO. That’s why I think Canadian listed foreign ETFs without currency hedging would be really welcome. BTW, I’ve written about both these issues in the past.

  9. CC,

    I’ve read your very useful posts on the Norbert Gambit and also on how the new Scotia iTrade commission free ETFs will make that option even more attractive (with DLR & DLR.U).

    Regarding US estate tax issues would you then recommend an ETF like CLU.C instead of purchasing IVV on the NYSE? I know they track different indexes, but would CLU.C be exempt from the US tax issues?


  10. @Daniel: CLU.C is Canadian domiciled and hence will not be considered an US in situ asset and therefore outside the US Estate Tax net. US Estate Tax may or may not be an issue for an investor because US Estate Taxes are effectively charged based on the ratio of US in situ assets to worldwide assets of an estate. If an investors current US holdings are less than the exemptions, US Estate Tax may not be an issue.

    An investor has to weigh the extra cost of CLU.C against the benefit of relief from US Estate Taxes. My suspicion is for the vast majority of Canadians, US Estate Taxes won’t be an issue. The MER of CLU.C is 0.73% compared to 0.07% for VTI. Also, CLU.C costs more in tracking error when held in a RRSP (the withholding taxes paid are not recoverable). In other words, this is a complicated topic because to add to the confusion, US Estate Taxes are constantly changing.

    I don’t mind sharing what I’m doing in my own portfolios. I own VTI because currently, I’m well under the exemptions available to aliens under US Estate taxes. In the future, I think currency unhedged versions of VTI will be available. If and when they do, I’ll prefer to hold them in taxable accounts.

  11. Thanks for the comprehensive replies CC.

    I see that for 2010 to 2012 the exemption for US estate taxes would be $5M and then $1.2M afterwards. Like you I am well under that limit 😉 I guess the question becomes whether you think fundamental indexing will get you .7% more than market-cap weighting. But that’s a different discussion.

    Thanks again for the responses.


    • @Daniel: Unfortunately, the exemption for non US residents is the based on the ratio of US in situ to worldwide assets. Example: If you own a total of $100K in VTI, VEA and VWO and your total worldwide assets was $1m, the exemption would be $500,000 (10% of $5M).

  12. Sorry, you are right I meant to say the Japanese Yen in my post above (second from the top). If I understand your response then my response is correct that in the hypothetical scenario that all things stayed fixed (NAV of foreign holdings in native currencies) and the US dollar jumped 5% against all of the foreign currencies then the foreign ETF should drop 5% because it would take 5% fewer US dollars to buy the same basket of foreign stocks. The fact that the ETF price may not move instantaneously would result in the ETF trading at a premium to its NAV and a brief arbitrage opportunity that would cause the ETF to drop in price relatively quickly.

    In the real world the fact that numerous currencies make up VEA and each will perform differently compared to the US dollar means (not to mention the underlying NAV is constantly fluctuating) that rarely will you see a 1:1 movement of the currency changes and ETF prices in regards to VEA.

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