Many investors would like to get 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 appear 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 eight year performance history of currency-neutral funds since they were first introduced in 2006, a different reality emerges.

Comparing S&P 500 CAD Hedged Index Fund TSX: XSP with USD-denominated IVV

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 US dollars. In the following table, the annual total returns in NAV terms of XSP are listed in Column 2 and the total returns of IVV in US dollars are listed in Column 3. The performance between the two funds is compared from 2006 because in 2005 and earlier years, XSP was a clone fund that used derivatives to skirt RRSP foreign content rules. While XSP’s MER of 0.25% is just 18 basis points (0.18%) higher than IVV, the difference in performance (shown in Column 4) is much wider.

A Canadian investor who bought $100 (Canadian) worth of XSP in 2006 would have ended up with $152 at the end of 2011. A US investor who bought $100 (US) worth of IVV, on the other hand, would be left with $175. In other words, the returns in XSP trailed that of IVV by an annualized rate of 1.9%. A Canadian investor who bet that the C$ would appreciate against the USD and opted XSP over IVV would have made the right call but lost money on the bet. The C$ appreciated at an annualized 1.05% against the USD but the tracking error of XSP wiped out all of the gains and then some. Interestingly, a Canadian investor who bought $100 (Canadian) worth of IVV in 2006 would have ended 2013 with $161, which is a total of 6% more than XSP, even though the C$ gained 9% during that time period.

  Year   XSP   IVV (in US$)   Difference
2013 32.50% 32.31% -0.19%
2012 15.56% 15.91% 0.35%
2011 1.07% 2.03% 0.96%
2010 13.47% 14.97% 1.50%
2009 22.95% 26.40% 3.45%
2008 -40.33% -36.94% 3.39%
2007 3.23% 5.43% 2.20%
2006 14.30% 15.68% 1.38%
Average 1.63%

 

Comparing Vanguard Currency-Hedged and USD returns

Vanguard Canada launched the S&P 500 CAD-hedged ETF (TSX: VSP) in 2012. We now have an opportunity to compare its returns with the USD returns of its underlying holding — the Vanguard S&P 500 ETF (VOO). As with other products, the currency-hedged ETF slightly outperformed the USD returns in 2013.

  Year   VSP   VOO (in US$)   Difference
2013 32.62% 32.33% -0.29%
Average -0.29%

 

Comparing TD e-Series Currency-Hedged and USD returns

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 under performs the TD e-Series US Index (US$) fund by an annualized 1.35%.

  Year   TD US Index (CAD) TDB902   TD US Index Currency Hedged TDB904   TD US Index (USD) TDB952   Difference
2013 38.62% 32.07% 31.43% -0.64%
2012 10.90% 15.40% 15.20% -0.20%
2011 4.10% 0.30% 1.50% 1.20%
2010 8.40% 12.60% 14.30% 1.70%
2009 6.70% 22.20% 25.70% 3.50%
2008 -21.70% -39.00% -37.40% 1.60%
2007 -11.10% 3.10% 4.90% 1.72%
2006 14.70% 14.00% 15.10% 1.10%
Average 1.26%

 

It is often asked why currency-hedged funds have exhibited such horrendous tracking errors. It turns out that the bulk of the blame can be attributed to the tendency of stocks and currencies to move in opposite directions (See post Why Currency-Hedged Funds have Large Tracking Errors).

So, what should investors do? If past performance is any indication and if investment performance is the only consideration, it appears that investors will likely be better off obtaining direct exposure to foreign equities without hedging away currency exposure. Owning foreign stocks directly has provided better returns in the past and it has done so with lower risk.

Note: This post was first published on Jan 3, 2010. It has since been updated with annual returns until 2013. In 2013, currency hedged funds generally outperformed the underlying funds in local currency terms. Still, the bottom line remains: currency-hedged US Equity funds still lag that local currency returns by a significant margin over the long term.

This article has 53 comments

  1. 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.

  2. 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

  3. Is XEM hedged to C$? I think you need to buy the Claymore CBQ for C$ hedged emerging market index?

  4. 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..

  5. Great post… a must read for anyone who is investing in these instruments. Thanks for your work!

  6. 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.

  7. 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.

  8. Oops — a couple of typos: “winds” –> “wins” and “canadian” –> “Canadian”

  9. Canadian Capitalist

    @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.

  10. 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.

    • Canadian Capitalist

      @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.

  11. @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 :(.

  12. 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.

  13. 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.

  14. 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.

  15. 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.

  16. Thanks for the interesting article. I’m glad there is starting to be more information available about this issue.

  17. 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).

  18. 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.

  19. 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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  23. 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.

  24. 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.

  25. This is a really important topic given the explosion in “currency-neutral” ETFs. You raise a good point which is that the currency hedged ETF reported in CAD has an enormous tracking error against the non-hedge ETF. The goal of the ETF is therefore clearly not being achieved.

    But, this does not tell us much about whether Canadian investors should be buying ETFs hedged to CAD or not. Ill put my conclusion up front and my logic down below: whether you’re a (typical) less-than-infinite-horizon investor or a truly infinite horizon investor, the hedged-into-CAD ETF (XSP) makes more sense.

    Here’s why:

    -you need to understand why the fund has tracking error. MER is not tracking error, its a fact, so lets ignore that aspect of the difference between the performance of the XSP and the IVV (its only 0.1%).

    -the real tracking error derives from the way the fund hedges its currency exposure. As stated in the detailed prospectus: “…the fund intends to employ a currency hedging strategy that is designed to hedge its exposure to U.S. dollars by entering into currency forward contracts and other derivative instruments with financial institutions..”.

    -Ie, what the fund does is it buys the underlying (in this case, IVV) and then, on a rolling monthly basis, buys forward currency hedges (sell USD, buy CAD). If the CAD goes up by exactly the amount that FX forwards suggest it should, then the tracking error should be extremely small, amounting to essentially the transaction costs of FX forwards, which are tiny.

    -but the currency can fluctuate in a completely different way from what forward markets imply – thats where the tracking error in this example comes from: the CAD appreciated by less than forward FX markets implied. So although the fund kept hedging its US exposure to CAD, it was paying a lot to do this because forward markets said that the CAD would appreciate a lot against the USD. in reality the CAD appreciate only nominally, so the hedged fund ended up hedging back into CAD at a rate which was quite a bit more expensive than it should have been.

    -But this can also happen in your favour: if the CAD goes up more than forwards imply, then the fund hedged into CAD would outperform the IVV! this hasnt happened over the past few years but – unless there is a systematic bias in currency forwards markets (there isnt) – you are likely to benefit from tracking error as much as you lose from it, especially over very long periods of time.

    -its therefore very hard to see a case for not being in the hedged ETF. unless you specifically want USD exposure, of think the CAD is in for a serious tumble (one bigger than what FX forwards already price in), your best bet is to stay in the hedged to CAD ETF (XSP) and sleep better at night.

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  28. @CC: Thanks for the update on the performance of these hedged ETFs. I had to chuckle coming across my above post from January 2010. RBC-DI now allows USD holdings in its RRSP accounts (thank you RBC) but not its RESP accounts (grumble, grumble…). And the Loonie has crossed parity and beyond before falling back some.

    On my wish list for the next two years: Vanguard Canada ETFs that give international exposure (similar to VTI and VEU) without currency hedging and with MERs equivalent to the US version. Hopefully some of the folks from Vangaurd Canada are reading your blog CC!

  29. @B.C. Doc: I’m not entirely sure why Vanguard decided on currency-neutral ETFs for the first batch of ETFs. Like you, I’m hoping that ETFs without currency hedging will be introduced soon.

    The only issue I see with US-listed ETFs is the trouble with US Estate Taxes. Otherwise, I wouldn’t even bother with Canadian-listed foreign ETFs since there are ways to do currency exchange for nominal cost these days.

  30. Great post, perhaps you could do a follow up post in the future, showing how the differences would affect an investor with $10,000 Cdn to invest, simply putting it into XSP, vs converting to USD, buying IVV, then 25 years later cashing out and converting back to CDN dollars. I would be willing to bet that you would still come out ahead even with conversion fees……

    • @Cal: Excellent idea. We could make some assumptions and see who comes out ahead under various scenarios. We could assume currency conversion costs of 1.5% each way, annualized stock market returns of 7%, hedging penalty of 1% and work out who comes out ahead for (1) US dollar remains the same. (2) US dollar appreciates by 25%. (3) US dollar depreciates by 25%.

  31. I wonder what products the majority of Canadian investors are using, hedged vs. un-hedged. This could be a simple explanation for their choice of releasing only hedged products.

    • @Sampson: It would be very difficult to make that determination. Even if we had currency unhedged foreign ETFs listed in Canada, we would also need to include Canadians holding US ETFs, a data point that may be impossible to obtain.

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  35. What about HXS? It is currency hedged, but it a swap. Is it possible that the swap index doesn’t have this erosion built in?

    • @Andrew F: It would be interesting to investigate how HXS performs against IVV. However, I think one will observe a similar lag in HXS as well because HXS tracks the S&P 500 CAD-Hedged index and a delta exists between the S&P 500 returns in USD and the S&P 500 CAD-Hedged index.

      • Even if there is a delta between the index that HXS follows and the S&P in Canadian dollars, it would be nice to know if that delta is more than the tax difference between IVV and HXS.

        After all, that’s what HXS does best: defer tax and transform foreign dividends into capital gains, in taxable accounts.

        I think that’s what most people want to know anyhow: am I better off with IVV or HXS; is the tracking error big enough to outweigh the advantages of deferred/re-structured tax?

  36. Awesome post. Thanks for the update. I’ve learned a bunch about currency-hedging (and why I won’t change my ways, to move to any currency-hedging) in large part because of your posts. :)

    Mark

    • Thank you for your kind words Mark. It took me a while to understand why currency hedging lag is so large. But for me the largest advantage of not hedging currency is the low correlation between currency and stock market movements that reduces overall portfolio volatility.

  37. In response to John and others. Currency hedging isn’t free. It costs real money that reduces the fund returns. The cost of currency hedging is not included in the MER. So currency hedged funds like the TD e-series that you mentioned are hit twice: once by the 15bp higher MER and again by the currency hedging costs. I am unsure of the magnitude of the currency hedging cost. I could not easily find this in the annual reports.

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  40. So I checked the 2012 total returns for HXS (horzions CAD-hedged S&P500 ETF) and VOO, the USD denominated Vanguard S&P 500 ETF. Both had a performance of 15.98% in 2012. To me, this suggests that HXS managed the currency hedge with zero drag (HXS CAD-returns matching VOO USD returns).

    However, in 2011, HXS returned 0.89% and VOO returned 2.1%. I’m not sure what’s going on here…

  41. Have you looked at the tracking error of XIN? As it actually tracks a number of foreign currencies does it display the same issue as XSP?

  42. Investors need to shake the illusion that owning U.S. stocks means full exposure to fluctuations in the U.S. dollar:

    http://www.michaeljamesonmoney.com/2014/01/currency-exposure-is-partly-illusion.html

    There is some exposure to be sure, but as you say, there is a cost to hedging.

    • Canadian Capitalist

      @Michael: Agree. I’m still surprised that the shortfall between currency hedged funds and the underlying is so large. The Canadian dollar has to appreciate at more than a 1% per year clip just to break even with a hedging strategy.

  43. With C$ facing a long term slide vis-a-vis US$, does currency hedging make sense?

  44. The opposite. Currency hedging only helps if the Canadian dollar is rising. It actually hurts when the dollar is falling in value.

  45. Greta article…I have always chosen directly owning foreign stocks and just as you mentioned, it did provide better returns and lower risks.

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