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moneysense.ca, 3/01/10
Performance of Currency-Neutral S&P 500 Index Funds
Many investors would like to have exposure to US stocks in their portfolio even if they believe that the US dollar is in a secular decline against other major currencies. In theory, currency-neutral funds seem to offer the best of both worlds: exposure to one of the world’s most dynamic stock markets without the baggage of the risk of a depreciating currency. However, if you look at the (short) performance history of currency-neutral funds, a different reality emerges.
First, let’s compare the returns of the iShares CDN S&P 500 Hedged to Canadian Dollars Index Fund (TSX: XSP) with the iShares S&P 500 Index Fund (NYSE Arca: IVV). In the following table, the annual total returns of XSP are listed in Column 3 and the total returns of IVV in US dollars are listed in Column 4. While XSP’s MER is just 15 basis points (0.15%) higher than IVV, the difference in performance (shown in Column 5) is much wider. Over the past 4 years, XSP has trailed the returns of IVV by an annualized rate of 2.99%. A Canadian investor betting that the C$ would appreciate against the USD and opting XSP over holding IVV directly would have been right on the first count but made no money on the bet. The C$ appreciated at an annualized 2.73% against the USD but the tracking error of XSP wiped out all the gains.
| Year | IVV (in C$) | XSP | IVV (in US$) | Difference |
|---|---|---|---|---|
| 2009 | 7.85% | 22.75% | 26.20% | 2.73% |
| 2008 | -23.33% | -40.14% | -36.64% | 5.52% |
| 2007 | -8.55% | 3.01% | 5.30% | 2.17% |
| 2006 | 15.74% | 14.11% | 15.80% | 1.46% |
This pattern of the currency-neutral fund exhibiting significant tracking error can also be observed in the TD e-Series index funds. As you can see in the following table, the TD e-Series US Index Currency Neutral fund underperforms the TD e-Series US Index (US$) fund by an annualized 1.97%.
| Year | TD US Index (CAD) | TD US Index – Currency Neutral | TD US Index (USD) | Difference |
|---|---|---|---|---|
| 2009 | 5.50% | 20.10% | 23.40% | 2.67% |
| 2008 | -21.70% | -39.00% | -37.40% | 2.56% |
| 2007 | -11.10% | 3.10% | 4.90% | 1.72% |
| 2006 | 14.70% | 14.00% | 15.10% | 0.96% |
moneysense.ca, 3/01/10
That’s terrible news because I’m a classic “couch potato investor solely in C$ ETF’s. Even though I might be missing out on this 2% aspect, the American currency / impending debt crises increasingly concerns me. Have you read recent posts by Eric Sprott or the recent Barry Allan interview on Squeezeplay? They both articulate pretty compelling arguments for the Americans defaulting on their debts which would mean horrible consequences for assets held in US$. I can’t watch my holdings and the currency like a hawk so I’m sticking for C$ hedged stuff for the foreseable future.
Very interesting post CC. I’ve been struggling with this. Actually do own XSP and have been fairly happy with its performance and tracking (it has been better in recent months it seems). But I’m not being entirely consistent as I own EEM instead of XEM (should switch to VWO anyway..lower fees). It’s true that XEM is not as liquid and spreads are a bit higher but I still look forward to being more decided on the subject.
The big question of course is… if you buy IVV or EEM in a Canadian based account (RRSP for example)..how do you hedge your US$ exposure? There are a few possibilities..but nothing convincing yet.
Thanks for putting that up together
Is XEM hedged to C$? I think you need to buy the Claymore CBQ for C$ hedged emerging market index?
wow, you are right. Had assumed it was but since there was too little liquidity, had not even looked at the exact description. You are correct, it is not hedged..
Great post… a must read for anyone who is investing in these instruments. Thanks for your work!
I’m really not following the point of this article. What I am understanding is that somehow you are saying that the currency neutral fund is under performing its US$ counterpart.
If that is the case I am finding it rather hard to follow your logic since you are comparing a C$ hedged fund verses a US$ fund and then showing the return of the US$ fund in US$ as well as C$. In every instance you have shown a huge benefit for the currency neutral fund (since it is reporting gains in C$!!!).
In 2009. According to your example XSP returned 22.75% vs. IVV returning 7.85%. Yes that is a huge tracking error, *in your favor*. XSP is a C$ fund which means comparing its returns to a US$ fund in US$ is really comparing 2 totally different currencies.
Maybe I am seeing your math completely wrong but it appears to me that your math proves the opposite of your commentary.
Cam: The goal of XSP is to get returns (when measured in C$) that match the return of IVV (when measured in US$). So, when you compare the 2009 figures of 22.75% and 7.85%, you are seeing a large currency gain less the tracking error. So, you’re right that the XSP investor winds out, but only because the canadian dollar performed well. If the two currencies stay together in the coming year, and if the trend CC has noted continues, XSP will underperform IVV.
CC: Nice analysis. I wouldn’t have guessed that the tracking error would be so high.
Oops — a couple of typos: “winds” –> “wins” and “canadian” –> “Canadian”
@Cam: As Michael points out in his comment, XSP aims to track the performance of IVV (in USD). Therefore, it is relevant to see how well XSP tracks the returns of IVV (in USD). As you can see from the tables, the difference between Column 3 (XSP returns) and Column 4 (IVV USD) returns is rather large.
Now, it is true that in 2009, IVV (in CAD) returned 7.85% compared to 22.75% for XSP. That’s because the CAD gained in 2009. However, look at 2008: IVV (in CAD) lost 23.3% but XSP lost 40%. Again, this is because the USD appreciated against the CAD in 2008.
Let’s look at the entire 4 year history though. If you’d invested $1,000 (CAD) in IVV at the start of 2006, you’d have $875 at the end of 2009. If you’d instead bet against the depreciation of the USD and invested in XSP, you’d have $863 at the end of 2009 even though the USD depreciated at the rate of 2.65% over 4 years.
The point is, you’d have lost all your currency gains (and then some) to the tracking error of currency-hedged funds. A 2 to 3 percent tracking error (assuming that’s what currency hedging costs) provides such a large hurdle that it is very unlikely that currency-hedging is likely to pay off for a long-term investor.
Great topic. But I’m a bit confused what you’re measuring here. I think the right thing to do is for each fund compare the currency neutral version with the unhedged version corrected for the change in USD/CAD exchange rates for that period. That will say whether the fund did its job. I don’t think that’s what you’ve done but I’m not sure.
@Observer: Let’s take a look at that tomorrow. For now, ignore Column 2 (IVV returns in CAD) and look at the performance differential between Columns 3 and 4. For now, the point I’m trying to make (but confusing the heck out of many readers) is that the currency-neutral funds track the performance of funds denominated in USD poorly.
@CC & @Michael: Thanks for the follow up. I would certainly agree with you that currency hedging doesn’t make a lot of sense for the long term investor using a buy and hold forever strategy. Currency hedging really only makes sense for a shorter term play when the uncertainty of the currency is greater than the tracking error.
Since we are Canadian investors looking at US products we also need to look at US$ conversion which, unless you are converting a lot of money at once, you are going to be getting close to that tracking error already. Just a bonus thought.
So for 2009 it made sense to use currency hedging. 2010 is also a time where the US$ is looking uncertain and gains *could* (extra maybe) be made through currency hedging. Long term though, I would seriously doubt that hedging will do anything more than cost money.
The real problem of hedging (beyond the gambling on currency) is the tax treatment. Hedged gains are taxed as interest income
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I think much of the tracking error can probably be attributed to how iShares hedges their currency exposure. I’m not sure what they do, but it is likely that they are trading currency futures or forwards to do it. If that’s true, then some tracking error is inevitable since currency futures only trade in discrete currency amounts. There is also the cost of trading currency futures and forwards, which have a bid-offer spread like many other securities. I’m not sure if all of this adds up to the tracking error referenced though.
It could be because the underlying transaction executers (banks) take a currency margin of up to 2% on passive FX transactions. Unless the fund manager actively asks for a good FX conversion rate on its forward contract, the banks are probably making a nice lucrative currency margin.
Most likely, the fund manager hedges on a passive basis not caring about the FX rate. The result is almost like paying a 2% MER as that appears to be the bid offer spread.
Checkout http://www.knightsbridgefx.com to obtain better than bank foreign exchange rates for businesses and private clients.
Another case to not allow someone to actively take care of your money. While the “currency neutral” funds look promising, they are dreadful, as someone must actively hedge against the currency, and then all rebalancing of the S&P will be affected by new currency adjustments. Once human element is brought in the returns are taken out.
I’m with Robillard in guessing that’s how currency is hedged. Its a little ironic that by using a currency hedged index fund, the benefit of indexing is lost.
Thanks for the interesting article. I’m glad there is starting to be more information available about this issue.
Thanks very much for this article, CC. Another aspect to this discussion is the spread that brokers take when receiving distributions from USD denominated securities like VTI (or DVY). I’m with iTrade and am very disappointed with their performance on this issue. I’ve spoken with a few managers at iTrade and they claim that all the major brokerages including iTrade are planning to follow Questrade’s lead and allow USD in RSPs (e.g. no forced conversions). This will make holding the underlying USD denominated security (like IVV) even more attractive than the currency hedged equivalent (XSP).
Great article CC and great f/u comment by DM.
My plan in October and November 2008 had been to buy US and global ETFs in USD denominations. As the loonie sank and I ran out of US dollars, I made a sharp alteration in my plans and made my remaining purchases in hedged ETFs from iShares Canada. At this point, about half of my US and global holdings are hedged while the other half are held in US dollars.
Due to tracking error, my plan is to start selling hedged ETFs and start buying/averaging into the US versions (through Vanguard and iShares) as the Canadian dollar (hopefully) climbs past parity.
Like DM, I am also very unhappy that RBC Direct Investments doesn’t allow me to hold US dollars in my RRSPs and RESPs. This issue has me considering an account transfer to Questtrade.
One reader brought up the MER rate and I think that is something that needs to be taken into account when making the analysis. 0.48% vs 0.33% for TD e-series US Index Currency Neutral and Us Index. The 0.15% additional MER definitely help contribute to the 1.97% annualized difference but you are right, there is more discrepancy that needs to be explained.
I’m looking forward to read what could cause such a difference.
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I think another way to look at it is to ask the question: should I invest in IVV or in XSP. If you invested 1 CAD in both, you would end up with 0.875 CAD if you invested in XVV and 0.864 CAD if you invested in XSP over the 4 year period. A difference of 1.1 %. The MER difference of 0.15 % accounts for 0.6 % of that 1.1 % (half). I picture the hedging as smoothing out exchange rate variations, not eliminating them. So over 1 year most of the exhange rate variation is not passed on to the investor whereas over 4 years, almost all of it is. So if you are going to hold XSP for a year or so and don’t have a good feel for where the exchange rate will go or think you might need to sell it even when the USD is at a short-term low value, buy XSP. Otherwise buy IVV. Strangely, when you do the same comparison of EFA VS XIN, the 1 CAD is worth 0.943 CAD if you bought EFA and 0.832 CAD if you bought XIN. That’s a bigger difference.
I estimated in http://howtoinvestonline.blogspot.com/2009/12/historical-effect-of-inflation-and.html how a portfolio including non-hedged US index, EAFE index and emerging markets would have done over 1992-2009 and it seems that hedging would have provided little benefit even without taking account of big tracking error performance penalties. For long holding periods hedging isn’t worth it I believe. Over short periods, I think Glenn is right – it smooths out variations … but if one only has a short term investing horizon, then equities wouldn’t be the best place for investments.