With the steep increase in the value of our dollar compared to other currencies, hedging against currency fluctuations has become popular and many US and international equity funds are now available in currency-neutral flavours. There are two schools of thought on currency hedging: one holds that currency fluctuations “cancel out” for a long-term investor and the other holds that currency fluctuations have a significant effect on equity performance and should be hedged away. Even if you are convinced of the need for hedging the currency exposure, there is one reason for thinking twice about hedging: cost.

Let’s take the iShares CDN S&P 500 Index Fund (XSP), which holds the iShares S&P 500 Index (IVV) and hedges the exposure to US dollars for an extra MER of 0.15%. At first glance, it seems to be a small price to pay for hedging. However, the extra MER doesn’t seem to be the only overhead for hedging. The total cost of the hedging shows up in the tracking error. IVV posted a total return of 15.78% and 5.3% in 2006 and 2007 respectively compared to the total return from XSP of 14.06% and 3.01%. In other words, XSP trailed IVV’s return in US dollars by 1.72% and 2.29% in 2006 and 2007.

Another example is the difference is performance between the TD US Index (US$) e-Series Fund (TDB952) and the TD US Index Currency Neutral (TDB904). The currency neutral version charges an extra MER of 0.15% but the tracking error was 1.8% in 2007 and 1.1% in 2006. Since the benefits of hedging are debatable but the costs are certain, it may be best to stick with direct exposure to foreign equity markets.

Updated October 26, 2010:
Both XSP and TDB904 again trailed their US dollar counterparts in 2008. Details in this post:
Currency-Hedged Funds Performed Poorly Again in 2008

The currency-hedged EAFE Index Fund (XIN) also exhibits large tracking errors: Performance of the Currency-Neutral MSCI EAFE Index Fund

This article has 44 comments

  1. This is something I have thought about myself. In fact, I think I may have even looked at the same (similar) numbers that you’ve mentioned. However, I would be hesitant to attribute the tracking errors you noticed specifically to the hedging. For instance TD US Index (US$) e-Series Fund (TDB952) also has a tracking error of 0.5% (2007) and 1.06%(2006). Though still less than the currency neutral version. Shouldn’t you compare the tracking errors of unhedged and hedged versions of the same fund?

    Nevertheless, hedging does come at a cost.

    Francis Chou has some interesting things to say about hedging in his latest Annual Report for his Chou RRSP and Chou Associates Funds (these funds have been burned by the rise in the CDN$):

    “And remember, hedging currencies comes with a cost…about 1% a year.”

    http://www.choufunds.com/pdf/AR07.pdf

  2. On second thought, I believe I misunderstood your numbers and I think the mistake is mine. Your comparisons seem correct.

  3. I didn’t realize the staggering difference in tracking errors until you pointed it out. XSP sounds like a ripoff.

    My portfolio is about 3% leveraged. I borrow US$ to buy US stocks, effectively hedging a tiny portion of my US allocation.

    According to the following website, there are other alternatives to currency hedging. Some are basically free. Do any of you hedge via futures?

    http://members.shaw.ca/RetailInvestor/hedge.html

  4. One could also hedge the currency exposure by taking positions in long or short positions in ETFs that track major currencies, which could be attractive if you can’t trade foreign exchange futures. There are a bunch that trade on the US markets, such as FXE and FXC.

  5. I agree with not hedging but the wild swings of the Canadian currency over the last few years makes me wonder if some hedging is appropriate for someone who is retired and is mostly invested in equities?

  6. I invest through a group plan, and index funds from only 2 major Canadian players were available to me through payroll deduction. One offered currency hedging in US and International indexes, while the other did not. The better performing funds were the hedged funds within the last 5 years (no surprise really, given the strength of the Can. $ vs. several international currencies). The clincher for me was that between my 2 choices, the hedged funds actually had a lower MER. This does not contradict CC, as my comparison is not apples-apples, merely a choice between 2 different products.
    I do agree that currency risk would tend to level itself out in the long-term, and isn’t really required for the long-term investor. Approaching and in retirement years, however, when you would really like to see some good returns on that sizable nest egg, you wouldn’t want to find yourself on the wrong side of the equation and find your international returns trounced by exchange rates. In this situation, you could find yourself working an extra couple of years to offset the effect. Then again, you could benefit the other way too…that’s the rub.

  7. Canadian Capitalist

    guy_m: I read the Francis Chou report through Larry MacDonald’s post. The hedging cost of 1% a year seems to be about right. We don’t have enough data yet to make a definite statement about hedging because many of the currency neutral funds used to be RRSP funds that mainly bought derivative instruments.

    FJ: Thanks for the link to the site on hedging. I disagree with the author’s views because I don’t think 1% per year is “cheap”. I personally don’t do hedge because doing so now reeks of performance chasing, IMO.

    Robillard: True. But I wonder how much such a hedging program would cost.

    Mike: I’m not so sure and I’d question if the retired investor has an appropriate asset allocation.

  8. On the assumption that currencies will always eventually drift back to some neutral valuation, currency risk adds volatility to returns without changing the expected yearly (arithmetic) return. Extra volatility does lower compounded returns over the long run, but I doubt that it is as much as the tracking errors that CC reports. If I’m right about this, then CC’s conclusion that most investors are better off without currency hedging is correct.

    A fraction of my spending is in the US anyway (travel for pleasure and conferences). So, exposure to US dollars for a fraction of my portfolio is essentially currency hedging. The last thing I need is to hedge this portion back to Canadian dollars.

  9. I always thought that if your asset allocation was to have 25% to US markets, that meant 25% to US currency as well. Hedging sounds like chasing performance right now since the CAD has done so well against the greenback. The fact that a lot of these currency neutral funds are ‘new’ seems like it’s just the banks way of trying to sell something new and hot to consumers.

    I suspect for long term investors the currency effect will cancel out for no net gain or loss.

  10. I find these TD efunds a little confusing. Currency neutral (TDB904) seems self explanatory. TDB952 is denoted with “US$”…that is supposed to mean unhedged? What is TDB902 then?

  11. Ah, I think I found the answer to my question. TDB902 is the C$ version of TDB952…..both unhedged. So if I wanted to invest without hedging, why wouldn’t I choose TDB902 instead of TDB952? This way I could save the ForEx vigorish of having to convert my money to USD ( (estimated at over 1% at TD) to invest in TDB952? It seems the ForEx expense of investing in TDB952 would cancel out your hedging savings outlined above.

  12. Canadian Capitalist

    Neil: The only difference between TDB952 and TDB902 for a Canadian investor is the currency the fund is denominated in. If you buy or sell TDB952, you’ll settle in US dollars.

    Flavours of an index fund

    Does anyone know where I can obtain returns for the MSCI EAFE Index in local currency? It would be interesting to check out the tracking error between XIN and MSCI EAFE Index (local currency).

  13. To my way of thinking, hedging most foreign investments would be self defeating. Investing in the securities of companies with most of their assets in a foreign country with a foreign currancy is part of normal diversification. Investing in a US, a German, a British or Chinese company is not a currancy speculation that needs to be hedged against. It is simply a diversification, albeit, outside Canada. The only time I would think about a currancy hedge for a stock in a foreign country would be if the foreign country’s currancy was really volatile, such as Turkey or Iceland. But then, I wouldn’t invest in those countries anyway.

  14. According to globefund, XIN doesn’t seem to track well with either MSCI EAFE (graph) or MSCI EAFE ($CDN) (table).
    Even TD International Index Curr Neut-e looks really bad.

    Strange…

    http://www.globefund.com/servlet/Page/document/v5/data/fund?style=globe_eq&id=54924&gf_uid=globeandmail.gf.02670815484

  15. I don’t fully understand how hedging is done, but I read it is through T-Bills and futures contracts, and that one of the characteristics of it was any returns of capital gains or dividends would actually show up as interest to the investor, is this true?

    Because of this, I thought it might actually be a *good* thing to hedge some funds that would be invested in trust with my children’s CCTB/UCCB contributions so the interest is taxed in the kid’s hands instead of mine…

    “Generally, when you invest your money in your child’s name, you have to report the income from those investments. However, if you deposited Canada Child Tax Benefit or Universal Child Care Benefit payments into a bank account or trust in your child’s name, the interest earned on those payments is your child’s income.”

    http://www.cra-arc.gc.ca/E/pub/tg/5000-g/5000-g-02-07e.html
    (under Line 121)

    Am I wrong?

  16. Canadian Capitalist

    Jordan: You’re right that currency-neutral funds generate high taxable distributions (subject of a post next week). However, I wouldn’t say that’s a good reason to invest in these funds because you can always sell some funds to realize earnings anytime you want.

  17. What about in the context I described where the interest likely won’t be subject to any tax at all?

  18. Canadian Capitalist

    Jordan: I guess what I’m getting at is that if taxes are your consideration, then there are other ways of realizing income at the hands of the child. For example, say you purchase TDB902 instead of TDB904 (assuming that you feel the currency neutral version isn’t worth the extra cost). TDB904 makes more taxable distributions than TDB902 but you have the option of selling a portion of your TDB902 (assuming you have gains) holdings and realizing taxable income. Doing so has the advantage of triggering a taxable event when you choose to do so. The capital gains are taxed in the hands of the child and you can use these gains to increase the ACB.

  19. The cost of hedging depends on how the hedge is set up. Taking long or short positions in futures contracts, for a corporation or a well-endowed investment fund with lots of foreign exposure, does not cost a lot. They simply have to stump up the initial margin with the exchange and top up their margin in the event of margin calls. The CME Canadian Dollar contract is based on a notional amount of $100,000 and the initial margin is US$2565. This in fact isn’t a cost. When the contract is netted out or settles, the whatever value is left in the margin account is returned to the contract owner.

    Forward hedging is typically at no apparent cost, though the banks that offer forward contracts make their cut on the bid-ask spread. Cash only changes hands when the contract is settled.

    Basically, futures and forwards have no real costs associated with setting up the hedge. Options hedging is another choice though it involves real costs. The cost associated with options hedging, by going long on calls or puts, is the cost of the contract.

    The managers of the currency neutral funds get away with charging a higher MER because they also need to manage their currency hedge. If they use currecy futures, the hedge needs to be rolled over every three months because currency futures settle quarterly. Depending on how the hedge is set up, the fund may face additional costs, particularly if it uses options, (though mutual funds are typically barred from options trading). There is also the cost of time and effort that the managers bear in managing and accounting for the hedge. So, there is some justification in those higher MERs.

  20. I think that having some diversification out of Canadian dollars is a good thing. But as you age, and expect to be spending your savings in Canada, you should likely look at reducing the exposure and do some hedging. However, a layman’s formula for this is far from obvious. As you age, you should be slowly moving into safer less volatile investments such as Canadian dollar denominated bonds anyway, so this issue of currency exposure as you age may just naturally work itself out. I’d have to give this more thought.

  21. I just discovered your website through the Globe and Mail and I’m finding it very instructive and interesting.

    I have a follow-up question to guy_m’s question at 2:26 on May 8: Is there a better option than the $CDN hedged MSCI EAFE (XIN)? The shares are from stock markets in different countries, so it seems to me that the fund would necessarily be hedged in one currency or another. Is there some way to get a better return than buying this fund in Canadian dollars?

  22. Canadian Capitalist

    Marina: EFA (iShares MSCI EAFE Index Fund) and VEA (Vanguard Europe Pacific Fund) are both ETFs that trade like stocks in US exchanges that a long-term buy-and-hold investor should consider. I’ve written about them earlier: check the ETF category.

    Link

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  24. A few comments.

    1. Many individuals/financial institutions regards those who hedge currency as making a call on currency movements. In actuality, it is the act of not hedging that one is making a fx currency call. By hedging, you are removing the impact of currency swings. By not hedging, you are a full participant.

    2. This may sound foolish, but think about it after you read it. The reason why many financial institutions don’t hedge currency risk is that they don’t hedge currency risk.

    3. Looking more closely at the ‘tracking’ error of TD’s e-series funds 952 and 904, a portion of this can be explained by the pricing structure of fx futures. During 2006 and 2007, in general, Canadian 3 month t-bills were lower than US t-bills by an average of .47%. Thus a perfectly hedged, perfectly tracked Cdn$ SP500 fund would underperform a US$ SP500 fund by this very .47%. Add on the additional .15% for the incremental MER, and the tracking error goes down from 1.8% and 1.1% to 1.18% and .48% respectively.

    Lastly, I don’t buy the arguement that currency hedging costs around 1.0% per annum. This is just an out for those who need to explain their rationale on why they don’t hedge currency risk, and thus have performed poorly during the last few years.

  25. Canadian Capitalist

    Lance: Currency hedging has its proponents who argue that currency swings could be extreme and seriously damage returns. They may have a point but I’d categorize those who hedge at certain times and don’t at others as making calls on currency movements.

    Interest rate differentials are a cost of hedging. In fact, economists theorize that the long-term movement of free float currencies are driven by interest rate differentials. If that is is the case, the cost of hedging (by bearing the cost of interest rate differential) is neutralized by the currency fluctuations for the long-term investor.

    I can easily see hedging costing 1% per year:

    extra MER + interest rate differential + bid-ask spread of currency contracts + extra taxes

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  27. I am buying high yield T Bills in another currency converting US dollars. how can i protect my self by buying options on the dollar in case it appreciates against this currency. I am talking of around 4% a quarter return on the T-Bill

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  30. This type of thinking is why all of your portfolio’s have dissapeared. you get what you deserve. even if it cost 1% to (i.e. a marginal opportunity cost) none of you realize the type of volatility embeded in fx 25-35%!!. and who the niave enough to says it cancells out in the long run?? my goodness, articles like this are exactly why retail does so poorly. keep buying and holding just like AIC…

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  36. CC, I think you should revisit this post. After a few more (volatile) years it’s interesting how poorly the hedged ETF (XSP) has performed.

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  43. With the rising Canadian dollar and because most of my imports are from the US, I no longer hedge any funds. The cost of hedging out ways the savings.

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