A shield from swings

By Vikram Barhat | November 22, 2012 | Last updated on November 22, 2012
5 min read

ETFs began as plain-vanilla investments, but over the last few years, exotic variations have emerged.

One of them is currency-hedged ETFs, which index foreign stock or bond markets to create protection against currency fluctuations.

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This hedge proves favourable when the Canadian dollar is strengthening against the referenced currency, says John Gabriel, an ETF strategist at Morningstar.

“Some might [say] the resource-rich loonie should be stronger than the greenback over the long haul,” he says. “However, keep in mind the USD enjoys reserve currency status,” despite the country’s numerous fiscal problems.

Thus, if there are shocks to the system stemming from Europe, China, or elsewhere, the U.S. dollar will rally. In such a situation, it makes sense for a Canadian investor to favour USD-denominated funds.

Don’t forget the tax advantages

OTTAWA-BASED SOFTWARE ENGINEER AND FINANCE BLOGGER Ram Balakrishnan says investors should think about withholding taxes lost by Canadian-based ETFs held in RRSPs. “Currency-hedged ETFs holding foreign stocks will pay a withholding tax, which is not recoverable through the foreign tax credit in an RRSP,” he says. “The effect of withholding tax could be large. The U.S. market yields about 2%. A withholding tax of 15% means a currency-hedged ETF holding U.S. stocks will incur a 30 basis points hit.” Thus, it’s more advantageous to hold U.S.-listed ETFs in an RRSP as there is no withholding tax on dividends. In a taxable account, says Balakrishnan, the tax is withheld, but it can be recovered upon filing your tax return. If you hold Canadian-based ETFs, however, the withholding tax is paid by the fund itself and subtracted from your return, even in an RRSP. It can never be recovered.

While predicting exchange rates can be a losing proposition, currency-hedged ETFs could make sense if an investor, with primarily U.S.-dollar-denominated investments, plans to retire in Canada, and will pay his bills in Canadian dollars.

“The investor may have a specific goal [he’s] trying to reach in order to retire; [hedging] could prevent the investor from falling short of his goal after the currency conversion,” he says. “You know how much you need in CAD; an investor in this case may not be able to afford an unfavourable currency conversion at retirement.”

The other benefit of using ETFs is cost: they generally have lower fees than their currency-hedged mutual fund equivalents.

Comes out in the wash?

Currency effects tend to even out over the very long term. However, not all investors have that much time. That’s why Guy Lalonde, portfolio manager at National Bank Financial, doesn’t always hedge positions, even though his clients hold both Canadian and U.S. ETFs.

“Given that our client’s future consumption will mostly be done in Canadian dollars, the overall preference is to hedge against currency fluctuations,” he says. “On the other hand, the goal of our portfolios’ structure is to exploit the risk/return and rebalancing benefits of combining several weakly correlated asset classes. In that regard, we see foreign exchange exposure as an additional asset class whose diversification properties maximize the risk-return of our portfolios.”

By contrast, investors planning to retire stateside could avoid currency hedging by holding USD-denominated ETFs.

Running some numbers, assuming a U.S.-dollar denominated stock, shows how a small currency fluctuation can dent overall returns.

Let’s say the Canadian dollar is at parity with USD and S&P 500 is at 1,000. A year later, the benchmark goes up 10% to 1100, and one USD is now worth CAD1.05, up 5%. As far as a Canadian investor is concerned, if the unhedged investment is sold after a year, the gains will be 15%: 10% equity plus 5% currency.

On the other hand, if a year later the USD weakens to CAD 0.97, a drop of 3%, and the equity gain remains 10%, the investor only gets a 7% return: 10% gain on equity minus 3% on currency.

When investors buy foreign-domiciled ETFs, they make two decisions says Vikash Jain, vice-president and portfolio manager with archerETF Portfolio Management.

“If you’re bullish on the equities, then you should buy it, but you should also ask yourself if you’re bullish on the currency,” he says. “If your view is that the [foreign] currency the ETF is denominated in is going to strengthen, then you buy an unhedged version” and vice versa.

So, when are currency-hedged ETFs not recommended? For starters, when investing in emerging markets, says Jain.

“One of the hallmarks of emerging markets is their currencies are generally undervalued; this is one thing that gives them their competitive advantages,” he says. “As these countries develop, their currencies will strengthen. If you’re a long-term investor, you’d not want to buy a currency-hedged ETF for emerging markets.”

There’s another reason for going unhedged in emerging markets. For the broad indices like the MSCI EM Index, there’s no effective way to hedge all the underlying currencies. Even the hedged ETFs only hedge against the USD, says Jain.

Hedging adds risk

What’s more, the mechanism behind these ETFs can introduce risk to a portfolio. Hedges tend to be imperfect, which leads to tracking error, says Gabriel.

“Most providers use monthly futures to hedge, but if the fund experiences any meaningful inflows or outflows in the middle of the month, then the hedge is no longer 1:1,” he says. “Therefore, there will be tracking error until the ETF manager resets the currency hedge at the next monthly interval.”

The amount of protection — derived from OTC currency-forward contracts — depends on the value of the underlying index. This means the hedging ratio can suffer a large tracking error in volatile markets, says Lalonde.

Given that our client’s future consumption will mostly be done in Canadian dollars, the overall preference is to hedge against currency fluctuations.”

“In 2008, the month of October saw the S&P total return go down 17%, while the U.S. dollar climbed 12% against the Canadian dollar,” he says. “By the end of the month, the hedging ratio was overweight by 29%.”

Rebalancing the hedge more often may limit this, but will also introduce higher management costs. Those looking to buy currency-hedged ETFs should assume they’ll end up paying fees or experience tracking error of about 1% above the MER.

It comes down to a trade-off. Investors need to weigh the potential benefit of asset-to-liability matching in the planning process against the additional costs associated with running a hedging strategy.

“I wouldn’t recommend that investors try to time their hedges [and] move back and forth based on how they think exchange rates will fluctuate,” says Gabriel. “Such speculative behaviour can be very detrimental to the value of a portfolio.”

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Vikram Barhat