[Note: This post was originally published on January 6, 2010. I've updated it with the data for the past two years on the performance of the iShares MSCI EAFE CAD-Hedged Index Fund (TSX: XIN) relative to MSCI EAFE local currency returns. Bottom line: Though the performance lag of the past two years was slight, the annualized lag for the past six years is still significant due to the large performance drag observed in 2009.]

I’ve looked at the tracking error of S&P 500 currency-neutral funds in past years but the tracking errors in the iShares CDN MSCI EAFE 100% Hedged to CAD Dollars Index (TSX: XIN) remained a mystery because I didn’t have the annual return data for the MSCI EAFE Index* in local currency. XIN holds the iShares MSCI EAFE Index fund (NYSE Arca: EFA) and hedges the foreign currency exposure that EFA’s holdings are denominated in, so that the returns of stocks will not be impacted by changes in the exchange rates between Canadian Dollars and Yen, Pound, Euros and other currencies. (As an aside note that even though EFA trades in the US, Canadian investors holding EFA are not affected by fluctuations in the exchange rate between the CAD and USD but are exposed to the fluctuations between the CAD and a basket of currencies such as Yen, Pound, Euros etc.).

Fortunately, MSCI Barra reports the returns of MSCI EAFE and other MSCI indices in local currencies on their website. Armed with that data, we can look at how well XIN tracks the MSCI EAFE in local currency terms. The following table shows the annual total returns of MSCI EAFE Index in its local currencies (column 2) with XIN (column 3). The results are consistent with our earlier analysis of the tracking error of XSP. XIN shows an annualized tracking error of 1.30%, which is lower than the tracking error shown by XSP but still wide enough to suggest that currency hedging is highly likely to be unprofitable.

 Year   Local Currency   XIN   Difference 
2011 -12.15% -12.71% 0.56%
2010 4.82% 4.59% 0.23%
2009 24.72% 18.11% 6.61%
2008 -40.27% -40.58% 0.31%
2007 3.54% 1.96% 1.58%
2006 16.46% 16.75% -0.29%

 
When a Canadian investor holds a foreign investment directly, they take on the risk that currency fluctuations will affect their returns. Sometimes, the fluctuations will be in the investor’s favour. Other times, as Canadian investors directly holding US securities can readily attest to, fluctuations will hurt returns. Canadian investors in the iShares MSCI EAFE Index Fund (EFA) would have experienced a significant boost from the currency effect. In local currency terms, the MSCI EAFE Index lost 17.3% over the 2006 to 2011 period. Since investors in XIN trailed the index by an annualized 1.30%, XIN’s loss over the same six year period is 23.73%. However, a Canadian investor holding EFA directly would have a loss of 13.91% over the same time period.

The verdict on currency-hedging then (based on an admittedly short history of just 6 years) is clear: Long-term investors are highly unlikely to profit from hedging their currency exposure because currency effects have to overcome significantly large tracking errors simply to break even. When currency effects are negative (as it was the case of the CAD/USD and US markets over 2006 to 2011), currency-hedging still did not show a profit due to tracking error. With positive currency effects (as was the case with CAD/basket and EAFE index over 2006 to 2011), currency-hedged investors are trailing even more because investors did not get the currency boost and paid for their hedging efforts through tracking error.

* – MSCI EAFE Index tracks stock markets in Europe, Australasia and Far East and holds securities that trade in countries such as Japan, the UK and Germany.