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Reader Question on EEM versus CBQ

May 13th, 2008 ·

The following question is from AJ:

I am wondering about an online article titled ETF Sector: Slop du jour published in the summer 2007 issue of Canadian Business magazine. The relevant section says: ‘The other building block advisers typically recommend is an emerging markets ETF. John De Goey, a senior adviser at Toronto-based Burgeonvest Securities, cautions against the most popular of these, the iShares MSCI Emerging Markets Index Fund (NYSE: EEM). Even though it has a 20% return over the past year and is well diversified, Canadians will expose themselves to currency risk since it trades in U.S. dollars. “You would have made money, but a good chunk of it would have been lost in the currency conversion,” De Goey says. Instead, he likes the Claymore BRIC (TSX: CBQ), which trades in Canadian dollars and boasted a 28% return in 2006. The drawback: it’s less diversified, offering securities from Brazil, Russia, India and China. Yet for De Goey, the currency risk of EEM is still greater than having less diversified holdings in a BRIC fund’.

Why would trading the same stocks in U.S. vs. Canadian dollars expose you to currency risk if the companies assets are all overseas? Even if the U.S. dollars falls you should be protected if the foreign currency moves upward with the Canadian dollar as you mention in this post: “You can essentially ignore the CAD-USD fluctuation for broad international ETFs like Vanguard Europe Pacific ETF (VEA), iShares MSCI EAFE ETF (EFA), Vanguard Emerging Markets ETF (VWO), iShares MSCI Emerging Markets ETF (EEM) etc., country-specific ETFs like iShares MSCI Japan ETF (EWJ), iShares MSCI Australia ETF (EWA) etc. and even ADRs that trade in US exchanges but are denominated in local currencies like Nokia (NOK)”.

I don’t understand why Mr. De Goey would come to a different conclusion. Am I missing something?

  1. The Claymore BRIC ETF (TSX: CBQ) uses ADRs listed in the US exchanges and hedges the CAD-USD fluctuations. So, you can think of CBQ as providing you with a narrow emerging market exposure and currency fluctuations of local currencies with the USD.
  2. A broad emerging market ETF like Vanguard Emerging Markets ETF (VWO) or iShares MSCI Emerging Markets Index Fund (EEM) will provide you with a broad emerging markets exposure along with currency fluctuations of local currencies with the CAD.

It is not clear to me why currency exposure in (1) is less risky than (2), unless you buy into the notion that the U.S. dollar will depreciate forever against emerging market currencies. Personally, I would pick VWO because of it (a) provides broad exposure to emerging markets and (b) cheaper than CBQ. Do you have any comments on AJ’s question?

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9 responses so far ↓

  • 1 Robillard // May 14, 2008 at 3:47 am

    The currency in which a fund is denominated does matter to an extent. Ignoring the issue of taxes, which CC has already detailed in earlier posts, currency denomination matters because currencies do not move in lock-step. Let’s say you buy EWJ, which holds securities denominated in Yen, but the ETF is denominated in US dollars. If the US dollar depreciates by 1% against all currencies and the Canadian dollar and Yen maintain the same exchange rate, then you would expect EWJ to post a 1% gain from currency translation, and you would lose 1% from translating the gain into Canadian dollars.

    Now suppose the US dollar depreciates 1% against the Yen, but only .5% against the Canadian dollar. EWJ would gain 1% from the value of its Yen assets, but you would lose .5% when translating it into Canadian dollars. One would expect the Yen to appreciate about .5% or so in Canadian dollar terms to eliminate this difference, but this doesn’t necessarily hold true. It’s a moot point anyways since the Yen should trade in a fairly wide bid-ask spread against the Canadian dollar, which would make arbitrage difficult. And you can’t sell EWJ for Yen or Canadian dollars for that matter.

    In the currency markets, triangular mis-pricing is uncommon, but usually get dealt-with by arbitrageurs or by widening the bid-ask spread. There are other arbitrage relationships that are also supposed to hold, such as covered interest rate parity, which can lead to fluctuations in currency relationships because of changes in short-term interest rates. Also, sometimes things can get thrown out of whack by unusually strong or weak demand for a currency. Typical causes include the carry trade (i.e. speculation), changes in a country’s current account and central bank intervention. I don’t think I’ve actually made this issue any clearer. Sorry.

  • 2 Canadian Capitalist // May 14, 2008 at 10:14 am

    Robillard: Thanks for your comments. One additional wrinkle with emerging market currencies is that many do not have floating exchange rates or even fully convertible.

  • 3 Rob // May 14, 2008 at 2:02 pm

    In defense of Mr. Goey (if his quote is accurate), is that he states that you would lose on the “conversion of the currency.

    I assume here he means simply the transaction of converting from CDN$ to US$ and back again to buy and sell the ETF…..and he says this can be avoided with simply buying the CDN$ version in the first place.

    That is giving him benefit of some doubt because his comment is a little ambiguous.

    Now, on the other hand, if he thinks the currency exposure is dictated by the denomination of the unit as opposed to the underlying investment inside the unit, he does not understand what he is talking about.

    For the record, I assume he has this correctly, and understands the matter as well as anybody.

    An easy way to understand this issue is to look at two versions of the same global equity mutual fund. It will work with ETFs as well but mutual funds work well in this analysis because they are identical portfolios, have audited returns ending the same days, and similar performance periods, etc… Fortunattely however, many funds will tradde in CDN$ and US$ as a convenience to those who do not want to convert currency.

    So look, for example, at the Trimark Fund in CDN$ and the same Trimark Fund is the US$ version. This can easily be done on http://www.globefund.com. The performance of the two funds is obviously different, but when you convert the US$ version back to the CDN$, the adjusted performance wil be the same. Why? They have to be the same because they are the exact same portfolio.

    (Why the two funds get ranked differently on Morningstar is beyond me and shows the limitations on using stars to evaluate investments - but that is another story).

    Ultimately, to understand the personal currency exposure of your own investements, you have to not only understand which countries the stocks in the fund, or represented by the ETF are located in; you also have understand the currency of the revenue and expenses of each of those companies, and finally you also have to understand any hedging strateiges each of those companies are employing.

    This will be a daunting, if not impossible, task and thankfully much of the various currency effects will cancel each other out.

    Like Robillard and his detailed explanation, I am not sure I have actually made the issue any clearer…but I hope it helps.

  • 4 Canadian Capitalist // May 14, 2008 at 2:48 pm

    Rob: Thanks for your input. Mr. De Goey is a very sharp guy, so he must have a very good reason for saying (if indeed he was quoted correctly) that currency risk in EEM/VWO is more than the diversification risk in CBQ.

  • 5 Charles // May 14, 2008 at 7:51 pm

    If you compare with the US$ version of CBQ, BIK. Both have the similar mer’s. I’ll just comment from a RRSP perspective.

    I’m in the group that think the USD is going through a period of weakness and will eventually rebound and thus think purchasing USD denominated securities to be of a discount of sorts in the long term. Yes fluctuations between USD and CAD will add volatility and exchange fees (I use Questrade USD RRSP) so that is a non issue for me. I can’t justify choosing CBQ over BIK considering USD speculation and liquidity due to volume being traded.

  • 6 rocco // May 15, 2008 at 12:00 pm

    I was wondering what happens if you are a canadian who bought MFC on the New-York stock Exchange.
    Do you get penalized with the dividends?

  • 7 Canadian Capitalist // May 15, 2008 at 5:17 pm

    rocco: That’s a great question. I’ve never bought Canadian stocks on U.S. Exchanges, so I’ll see if I can dig up anything to answer your question.

  • 8 Albin Forone // May 18, 2008 at 1:33 pm

    FYI all, there is a good and relatively cheap no load (1.3% MER) mutual fund that broadly replicates the EEM / VWO MSCI index and I believe (grateful for correction) it is C$ hedged: it is CIBC Emerging Market Index CIB519. Historically, this index has been overweighted Korea, not so bad right now, and certainly has a sprinkling of markets not in the BRIC. Although the CIBC fund MER doubles that of ETFs, there are no trading fees so it lends itself to dollar cost averaging - on that basis may be cheaper. (I tend to DCA into C$ index MFs until I have a large enough position to sell it and buy 1000 units of an equivalent ETF, to minimize trading expenses.)

  • 9 FSM // Jul 4, 2008 at 11:37 pm

    Newbie question on CBQ.

    In going through my statements I noticed that CBQ had a dividend distribution on March 13th (say $50) but had it reinvested (so the $50 goes back in the fund but I get no additional shares). My understanding is that this increases my cost base by that amount.

    Am I missing something or is this a bad deal if I hold CBQ in a registered account?

    Thanks!

    FSM

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