In past posts, I’ve pointed out that currency-hedged funds such as the iShares S&P 500 (CAD-Hedged) ETF (XSP) and TD US Index Currency Neutral e-Series Fund (TDB904) exhibit large tracking errors that cannot be explained by their higher MER alone. I’ve never had a good explanation for why is so. And more importantly, I couldn’t answer with conviction whether large tracking errors are simply a statistical anamoly or whether negative tracking errors are likely to persist in the future. A recent paper by Raymond Kerzérho of PWL Capital (thanks to Larry MacDonald for pointing to this in a recent post) titled Currency-Hedged S&P500 Funds: The Unsuspected Challenges provides a conclusive answer to both these questions.

[Tracking Errors in Currency-Hedged Funds Larger than MERs]

The paper breaks down tracking error into four components: (1) Difference in management fees (2) Transaction costs such as commissions, bid-ask spreads and other administrative costs (3) Interest-rate differential between Canadian and US exchange rates and (4) Residual-Currency Effects (RCE).

The last of these — RCE — is the most interesting because it accounts for the bulk of the observed tracking errors. RCE results from fluctuations in stock prices. Here’s one example from the report: A S&P 500 currency-hedged index fund with $100 million in assets starts off with a $100 long position in the S&P 500 index and a $100 million short position in US dollar forward contracts (all US dollars). If the S&P500 index advances 3%, the fund will be long $103 million in the S&P 500 but the forward contracts cover only $100 million. The fund is underhedged by $3 million. If the US dollar falls by 3% during the same time period, the fund will have a tracking error of +0.09%. If the US dollar increases by 3%, the fund will have a tracking error of -0.09% (the fund outperforms the index).

RCE will give rise to a positive tracking error (fund underperforms the index) when stocks and currency moves in opposite directions and negative tracking error (fund outperforms the index) when stocks and currency moves in the same direction. If stock prices and currencies move randomly with respect to each other, you would expect currency-hedged funds to underperform at certain time periods and outperform in other time periods (reader Avon Barksdale made this point in Why Currency Hedging is Necessary).

It turns out currency and equities more often than not move in opposing directions. This won’t be a surprise to investors who have watched US equities zig when the US dollar zags and vice-versa in the recent past. But this observation is not limited to the 2006-09 time period. Mr. Kerzérho estimates that the -0.38 correlation between the S&P500 and US dollar in the 1980 to 2009 period would have resulted in a RCE hit of 0.40% per annum for a currency-hedged portfolio. In fact, Mr. Kerzérho found that 60-month rolling correlation between US stocks and the US dollar never moved into positive territory in the 1980 to 2009 period. Such a long history suggests that the 2006-09 period isn’t simply an anomaly. Mr. Kerzérho concludes [emphasis his]:

Based on this evidence, I believe that a negative correlation is likely to persist rather than revert towards zero, and that this therefore imposes a large inefficiency cost on the unitholders of S&P500 currency-neutral funds.

This article has 14 comments

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  2. Very insightful! Can’t wait to read the full paper when I have time.

  3. Great post on an important and often misunderstood issue. Just downloaded the paper and look forward to reading it. Thanks, CC.

  4. Your bias is to own US equities unhedged. You are still young and currency flutuations might well even out over your life.

    However; how do you advise retired Canadian non-snowbirds concerned about the US printing money to “help” with their debt load (thereby de-valuing the US Dollar aganst the Canadian Dollar)?

    Should such persons buy US equity ETFs with a hedge feature, or just stay away from US equities altogether?

    • @Dr. Dale: If I was retired, I would still own some equities. And a portion of those equities would be in foreign markets for the diversification benefits still available even with increased correlations between markets. As long as some portion of an investor’s portfolio is in foreign stocks, evidence suggests that those stocks should not be currency-hedged for three reasons: (1) Currency unhedged portfolios are not much more volatile than currency-hedged ones (and less volatile for US markets) and (2) Currency hedging appears to add about 1% extra cost and (3) Some currency unhedged positions reduce overall portfolio volatility.

      Also, I do not subscribe to the thesis that the US dollar is going to endlessly depreciate against the Canadian dollar. A very strong Canadian dollar will create significant economic headwinds. The Bank of Canada will not stand idly by if we are afflicted by the “dutch disease”. The Bank in past has made noises about intervening in currency markets if the dollar becomes too strong. I don’t think it is an empty threat.

  5. I hope that you are right about “dutch disease”.

    I am less sanguine.

    Good post though.


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  10. Any theories why HXS is also exhibiting high tracking error per ? 1.2% vs the index when it is supposed to be a total return swap that automatically gives the index return gross of MER 0.15% and swap fees 0.30% with the index puzzles me and the rep I spoke to at Horizons could not give me an immediate answer. There is 1.2 – 0.45 = 0.75% unexplained tracking error. The research report on the Horizons website says the tracking error should only be 0.45%.

    • @CanadianInvestor: Interesting observation Jean. Like you say, the whole point of these Horizons ETFs is to avoid bad tracking errors. I do not have an idea as why HXT exhibits so much tracking error. I’ll try and find out from Horizons.

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