International Tracking Error: Part 3

In this final post in the series on why international index funds performed so poorly in 2009, it’s time to look at currency hedging.

Currency hedging is a strategy designed to smooth out the fluctuations in the value of the Canadian dollar relative to other world currencies. For example, in a fund that tracks the EAFE index (which covers Europe, Japan and Australia), the stocks are denominated in pounds, euros, yen and Australian dollars. If the UK holdings go up 10%, but the loonie rises in value by 4% relative to the British pound, an investor’s return in Canadian dollars is only 6%. To protect against this potential loss, a fund can buy forward contracts designed to offset the currency swings. Ideally, Canadian investors in a hedged EAFE fund should receive the full 10% return of their UK stocks. (If you’d like to learn more, RBC offers a nice explanation of currency hedging.)

It’s a reasonable strategy: if all of your liabilities are in Canadian dollars, it makes sense to hold your assets in Canadian dollars, too. Yesterday’s guest post on Canadian Capitalist also makes a compelling argument that currency hedging reduces volatility for investors with foreign holdings. Others argue that currency swings go both ways and should even out over the long term, and besides, a bit of foreign currency in your portfolio adds diversification.

But leave aside the hedge-or-no-hedge debate for now. Let’s instead ask whether the strategy does what it’s supposed to do. In international index funds in 2009, at least, the answer was a thunderous no.

Exhibit A is the iShares MSCI EAFE Index Fund (XIN), which lagged its index by 5.34% last year, by far the highest tracking error of any iShares ETF. The US-listed version of this fund (EFA) tracked the index perfectly, so the performance drag was almost entirely due to the hedging strategy. Claymore’s Japanese Fundamental (CJP), emerging markets and US funds also had large tracking errors, partly due to hedging. Bottom line, Canadians looking for — and paying for — protection from a rising loonie didn’t get it.

That shouldn’t be surprising. As Rob Carrick writes, “Hedging is like playing hockey with a baseball bat. It can be done, but the results are clumsy.” Both iShares and Claymore explained to me that they reset their hedges every month, but the indexes are adjusted daily. Between reset dates, if the stock market moves dramatically, or if the fund experiences a large inflow, some foreign currency can be left exposed.

Here’s how: assume that on the first day of the month a fund holds European stocks valued at  €100 million and the manager buys a forward contract covering that amount. Over the next couple of weeks, the market surges and the stocks are now valued at €107 million. Giddy investors start pouring money into the fund and soon it holds €112 million worth of equities. But the currency hedge covers only €100 million. So now, if the euro moves up or down before the month is over, €12 million will be affected by these fluctuations. That can open a wide gap between the fund’s performance and that of the index.

Hedging can be even more ham-fisted: Claymore’s emerging markets ETFs (CBQ and CWO) are hedged against the US dollar, but the underlying securities are denominated in Chinese yuan, Brazilian reals, and a host of other currencies. This is called a proxy hedge: Claymore is assuming that the US dollar will move in concert with emerging markets currencies, which are too difficult to hedge directly. However, Canadian Financial DIY has pointed out that this assumption doesn’t hold up to scrutiny.

Finally, currency hedging ain’t cheap. Buying and selling forward contracts adds frictional costs to the fund. (iShares estimates that it results in a drag of about 0.15% annually.) That might be worth it if the strategy delivered what it promised. But over the last few years, the record of currency-hedged funds has been disappointing, to say the least. Unless it improves, I’ll continue to recommend that Canadians get their international equity exposure through US-listed ETFs from Vanguard and iShares.

7 Responses to International Tracking Error: Part 3

  1. Canadian Capitalist May 5, 2010 at 9:37 am #

    I agree with your conclusions and I personally plan on continuing to hold Vanguard shares directly. Some investors may disagree but regardless of whether investors decide to hedge their currency exposure or not, it is far more important to pick one strategy and stick to it. Investors should be careful not to chase currency movements choosing to hedge in some holding periods and not to hedge in others.

  2. David May 5, 2010 at 7:45 pm #

    Great series! Thanks for the detailed explanation. I also will continue to hold my Vanguard shares directly.

    I was wondering if you might entertain another such series of post explaining the actual fair value price of an ETF.

    I.E. how the NAC is calculated? This is an easy one, I know…but, is it accurate, i.e. how does the ETF account for the liabilities of its holdings? Should that be considered in the NAC? How does the number of share holders effect the price and how does the holdings themselves effect the price?

    May not require a series of post. But, I would love to have that explained to me properly. Any searching I have done on the subject always returns very basic info.

  3. Avon Barksdale May 5, 2010 at 9:39 pm #

    If you really believe that iShares Canadian dollar hedged ETFs will consistently underperform their unhedged brethren on the NYSE then you need to act on that knowledge. What you are saying is that a bona fide market inefficiency exists between IVV and XSP (that is you are saying BlackRock does not know how to currency hedge). In that case the obvious arbitrage is to short XSP, take the proceeds and convert to USD, and buy IVV. Do this every day or month or whatever time period you want and close out your position at the end of the year. You will make money (without using any of your own) with probability approaching 1 if you are right on the inefficiency. Better yet, you can synthetically construct quanto spread options on the performance of XSP and IVV and again you will make riskless profits. Trust me, the hedge funds, the banks, and iShares (BlackRock) are completely aware of all these methods (and tons more) – and if any arbitrage opens up, you had better believe that it will be closed by program trading in an instant.

  4. Marc Ryan May 6, 2010 at 12:31 pm #

    Great article.

    What I find objectionable is that the hedging cost is not disclosed as part of a fund’s MER. If it were investors could make an enlightended decision whether to choose a hedged or unhedged fund. In the absence of inclusion in the MER few investors even realize the existence or amountof this cost and the adverse impact on tracking the related index.

    Marc Ryan
    IndependentInvestor.info

  5. Canadian Couch Potato May 6, 2010 at 12:53 pm #

    Marc: I suppose the funds would argue that hedging costs are in the same category as trading expenses: they’re not a “management expense” and they can vary from year to year.

    What I’m coming to appreciate more and more is that investors should spend less time obsessing over small differences in MER and spend more time looking at tracking errors. If two funds track the same index, the one to buy isn’t necessarily the one that’s a couple of basis points cheaper. It’s the one that has a better record of tracking that index.

    The problem is that this is difficult (you usually have to look it up in the funds’ regulatory filings), and many Canadian ETFs have only been around for a couple of years, so they have no meaningful track record.

  6. SophieW May 8, 2010 at 7:18 pm #

    I’m curious if this same issue arises in index funds. I notice in your model portfolios that for the TD e-series funds you chose the hedged funds for both the US and International holdings.

    Do you still recommend these funds?

  7. Canadian Couch Potato May 9, 2010 at 9:10 am #

    Sophie: There’s no reason to expect that currency hedging would be any more efficient in an index mutual fund. I use the hedged versions of the e-Series funds in the Global Couch Potato simply because most Canadians seem to be more comfortable hedging their currency. I think it makes many people more comfortable, and that’s important if you’re just starting to invest on your own. (I recommend the hedged versions of the Altamira index funds because they’re actually a lot less expensive than the unhedged versions.)

    As long-term DIY investors becomes more sophisticated and understand the issues more thoroughly, they will likely consider portfolios more like the Sleepy Portfolio, which unhedged ETFs.

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