[Note: The following post was originally published on Jan 3, 2010. I've now updated it with the 2012 annual returns for XSP and IVV. The bottom line is that the performance of currency-hedged funds still lags that of the local currency fund by a significant margin.]
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 US dollars. In the following table, the annual total returns 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 that were in place at that time. While XSP’s MER of 0.25% is just 16 basis points (0.16%) higher than IVV, the difference in performance (shown in Column 4) is much wider.
A Canadian investor who put $100 (Canadian) in XSP in 2006 would be left with $114.72 at the end of 2011. A US investor who put $100 (US) in IVV, on the other hand, would be left with $114.03. In other words, the returns in XSP trailed that of IVV by an annualized rate of 2.08%. A Canadian investor betting that the C$ 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 by investing in XSP. The C$ appreciated at an annualized 2.1% against the USD but the tracking error of XSP wiped out pretty much all of the gains.
|Year||XSP||IVV (in US$)||Difference|
This pattern of the currency-neutral fund exhibiting significant tracking error can also be observed in the TD e-Series index funds. As you can see in the following table, the TD e-Series US Index Currency Neutral fund underperforms the TD e-Series US Index (US$) fund by an annualized 1.57%.
|Year||TD US Index (CAD)||TD US Index – Currency Neutral||TD US Index (USD)||Difference|
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.