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moneysense.ca, 11/01/09
Revisiting the Tracking Error For Currency-Hedged Funds
Larry MacDonald wondered how I calculated the numbers reported in the post on the historical tracking error of the iShares CDN S&P 500 Index Fund (XSP) as the tracking error chart on the iShares website reports a much smaller error. For 2006, 2007 and 2008, the tracking error reported by the iShares website is 0.34%, 0.56% and 1.31% respectively. Recall that the tracking error reported in the earlier post was wildly different for the same years: 1.73%, 2.30% and 3.5%.
While there is a small difference in the total return calculation for XSP, the bulk of the difference can be attributed to the annual return calculations for the benchmark. I used the total return of the iShares S&P 500 Index Fund (IVV) as the benchmark and my calculations agree with the numbers reported by the ETFConnect website. As the iShares website notes that XSP tracks the “the S&P 500 Hedged to Canadian Dollars Index”, it is entirely possible that the difference in tracking errors can be attributed to using different benchmarks.
But for investors, all this discussion of benchmarks is academic in deciding whether they want to hedge their currency exposure or not because the bottom line is simple: what is the difference in performance between IVV in Canadian dollars and XSP? On this score, the short history of XSP isn’t very encouraging. Over the 3 years ending 31st December 2008, XSP lost 29.68% compared with a loss of 22.75% for IVV. During the same time period, the Canadian dollar depreciated from 86 cents to 82 cents, meaning that an unhedged exposure to IVV would have lost even less. Even if the dollar had instead appreciated to 92 cents over the same time period, the returns in Canadian dollars for IVV and XSP would have been the same (ignoring currency conversion charges). Given the rather significant costs involved in hedging, it seems that long-term investors will almost certainly be better off with a direct holding in foreign stocks and taking their chances with foreign currency fluctuations.
moneysense.ca, 11/01/09
I think that if you plan to buy and hold, it is good idea not to hedge currency risks.
However, if you want to do market timing and can determine foreign currency will depreciate vs the Canadian dollar, than use a currency neutral fund. If the foreign currency will appreciate vs the Canadian dollar, it is better not to hedge anything.
By the way, using the term “hedged funds” is a bit confusing. When I first read the title, I was thinking “hedge funds”. Does “hedge funds” have tracking error? I don’t know what “hedge funds” track to be honest.
I wonder how many people buy these without really having an opinion about the direction of the exchange rates. It’s possible that a large part of the attraction is in comparing an unhedged investment in the US over the last 5 years to the S&P 500′s returns in US dollars – plain performance chasing. But if you don’t specifically think that removing the exchange rate exposure will enhance the returns consistently, then you might as well hedge it with a random number generator.
It’s interesting that the benchmark results are so different. Maybe it uses daily averages instead of intraday values – that doesn’t seem like it would have a big effect though. I can’t think of any other way it could track something other than the US dollar S&P 500 returns.
CC:
I spoke to the head of business development at iShares and she confirmed, as you suspected, that they use a currency hedged version of the S&P 500 (I’ll be posting her response in my blog tomorrow).
CC
(correction to my post above)
I spoke to the head of business development at iShares and she confirmed, as you suspected, that they use a currency hedged version of the S&P 500 as their benchmark (I’ll be posting her response in my blog tomorrow).
Great post – not many people would have been able to figure this one out.
I’m not a fan of currency hedging, but the reality is that the Canadian stock market is not that diversified. Buying an etf for US or Europe markets means diversifying in both stocks and currency. If you want the market diversification but not the currency diversification then maybe hedging the currency is not a bad idea.
I wonder if many Canadians buy the Canadian-hedged ETF because they’re on the TSX and priced in Canadian dollars. The idea of buying in the US with currency conversion seems like a “hassle” so they avoid it. Both iShares and Claymore use hedging on almost all Canadian ETFs holding foreign investments. Presumably they don’t want to be redundant to their own products in the US?
What I’d like to see are unhedged versions of the US iShares funds, denominated in Canadian on the TSX, and *interlisted* with their American counterparts. That way, even if trading is thin, arbitrage can occur with the heavier-traded US versions.
Regarding the claim that hedging is expensive, I actually read Claymore’s ETF prospectus recently looking for a break down of expenses, and I might have found something related to this.
There is a disclaimer in there that if they buy their own ETF to widen their index holdings (like the International index also holds their own Canadian & Japan ETFs) that you won’t be double charger their management fee, except in the case that the other ETF needs to be hedged, then they can add on 0.05% fee.
So my guess is this might actually be what the currency hedge costs them to implement. This seems down right cheap compared to a consumer paying for currency conversion fees. It also means the tracking errors an even larger part of the problem.
CC, an excellent post. If Canadian investors knew the real costs of using currency hedged funds, I think they would be much less interested in them.
If it helps I’ve just calculated the total 2008 returns of the RAFI FTSE US Fundamental Index being hedged or in USD.
Claymore’s Index (CLU) is in CAD with a 0.65% MER
PowerShares’s Index (PRE) is in USD with a 0.39% MER
CLU returned -41.7%
PRF returned -40.2% or -26.8% in CAD
For the test I didn’t use the actual index or tracking error rate provided on their sites, but created a globefund.com portfolio which adds in the distributions.
I even used a 1% retail currency conversion fee to buy PRF, so this shows that hedging, a higher MER and maybe other fund differences had about a 2.5% drag/difference.
Cheers
EconStudent: I corrected the headline. I agree that using “hedged” Funds is very confusing.
SP: Like much of the fund industry, these funds serve the demand due to performance chasing. When these funds were first introduced, the rapid appreciation of the loonie was topmost in investor’s mind and they believed that the small extra MER was the only cost of these funds.
Larry: Thanks for the mention and checking with iShares.
Mike: I guess the costs of hedging are so large that it may be better for investors to take their chances with direct holdings in foreign stocks.
Jordan: That’s another interesting data point. A 2.5% performance drag is a lot, especially considering that currency conversion charges will be amortized over a long time.
One could open a currency account ( taxable however) with most forex brokers and put only 1% down. Hedging however does tie out some of your capital which could be used to invest in other asset producing ventures. Most brokers would pay you a money market yield on your funds that you hav put as a collateral in the fx account.
@CC, thanks very much for this discussion, I’ve found it very useful. I’m still new to DIY investing so I’m not sure about this, but looking beyond USD, are there ETFs denominated in Euros that I could invest in directly in order to get European equity exposure? I see the underlying ETF to IShares Canada’s currency neutral MSCI EAFE offering is EFA, which trades in USD. Is USD the currency of choice for most pan-European or international equity ETFs? Even if I could find an appropriate Euro denominated product, would it be too much to expose myself to both USD and Euro currency risk? Thanks very much for anyone’s comments.
@DM
I know you didn’t ask me, but I had the same sort of question and found a really great article that answered it for me on the Canadian Financial DIY blog.
http://canadianfinancialdiy.blogspot.com/2007/05/clarification-of-foreign-exchange-risk.html
It shows that when you own an international investment based in USD you are actually still exposed to the underlying currency.
@Jordan,
Thanks very much, I’ll take a look.
You aren’t exposed to more exchange rate risk by making foreign investments in a third currency, but you may be exposed to more currency conversion fees when buying and selling. I wonder how the MER on something like the TD e-Series EAFE fund compares to a US ETF when this is taken into account…
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So it would be a better idea to convert my Canadian funds to US funds and purchase IVV vs XSP? I noticed using google finance and comparing the period Jan.4 2002 – May.19 2009, IVV lost -21.30% while XSP lost -42.10%? How’s this possible??