Currency Hedging in International Funds

Currency hedging can be confusing for investors who use index funds and ETFs that hold foreign stocks or bonds.

The basic idea, which I have written about before, is not terribly hard to understand. If a Canadian buys an unhedged index fund that tracks US stocks, her returns will suffer if the US dollar declines against the loonie. (On the other hand, she’ll get a boost if the greenback appreciates.) If a fund uses currency hedging, however, you can expect the same return as the underlying stocks, regardless of the currency fluctuations.

But things get complicated when there is more than one foreign currency involved. The iShares MSCI EAFE Index Fund (XIN) covers more than 20 countries, and the stocks are denominated in British pounds, Japanese yen, euros, Swiss francs, Australian dollars and a few others. The hedging strategy is designed to eliminate the effect of fluctuations in all of these currencies compared with the loonie. So investors in XIN should expect the same return in Canadian dollars that local investors in Europe, Asia and Australia receive in their own currencies.

US funds rarely use hedging

I’m not sure why, but US-listed ETFs tend not to use currency hedging for international equities. As a result, Canadians who invest in funds such as the iShares MSCI EAFE Index Fund (EFA)—the US version of XIN—or Vanguard’s Vanguard MSCI EAFE (VEA) are fully exposed to the pound, euro, yen and other foreign currencies.

If you expect the Canadian dollar to remain strong against most or all of these overseas currencies, then it makes sense to use XIN. However, if you do not want to incur the added costs of hedging (or if you share my opinion that exposure to several currencies diversifies to your portfolio), then consider an alternative such as EFA or VEA.

Although these US-listed ETFs are cheaper than their Canadian counterparts, several investors have told me they avoid them because they don’t want to be exposed to the risk of a falling US dollar. Others have taken the opposite view, arguing that now is a good time to buy these ETFs, because the US dollar is so low.

No exposure to the US dollar

This confusion is understandable, since both EFA and VEA are bought and sold in US dollars. Remember, however, that the underlying stocks are denominated in a basket of overseas currencies. Therefore, the strength or weakness of the US dollar has no effect on the return that international equity ETFs deliver to Canadians.

I recently spoke with Vikash Jain, portfolio manager at archerETF, an investment firm with a global outlook. He clarified this idea using the example of a Canadian buying a US-listed ETF that holds stocks denominated in euros.

“You take your $100 Canadian and you convert it to US dollars to buy the ETF,” Jain explained. “Then the manager of the ETF is going to sell those US dollars and buy euros. Now you have bought US dollars and sold US dollars — so the transactions cancel each other out, and therefore you have no US dollar exposure. However, you sold Canadian dollars and you bought euros. So now you are negative Canadian dollars and positive euros. When you sell the ETF, it’s just the reverse process: the manger sells the euros and buys the US dollars, then you sell the US dollars and buy Canadian dollars.”

So if you’re adding international equities to your portfolio, take a good look at low-cost US-listed options, especially from Vanguard. You may incur currency conversion costs when you buy and sell these ETFs on the New York exchanges, but you will not be exposed to the US dollar in any way.

22 Responses to Currency Hedging in International Funds

  1. aln April 4, 2011 at 9:32 am #

    But how does taxation fit in? Does Uncle Sam not take 15% of my ETF lowering my return by that much right off the mark? If I put US listed ETFs in a US dollar account do all dividends etc stay there and not generate currency conversion costs.

  2. Canadian Couch Potato April 4, 2011 at 11:57 am #

    @aln: Actually US-listed ETFs can be more tax-efficient than their Canadian versions. If a US-listed ETF is held in an RRSP, there is no withholding tax on dividends. In a taxable account, the tax is withheld, but it can be recovered when you file your tax return.

    If you hold XIN or a similar fund, the withholding tax is paid by the fund itself and subtracted from your return, even in an RRSP. It’s never recoverable.

    Remember to keep the withholding tax in perspective. Assuming a 2% dividend, the tax shaves just 0.3% off your annual return.

    Yes, if you can hold a US dollars in your account (which is the case with all taxable accounts), the dividends get paid in US dollars and there is no forced conversion. Unfortunately, most RRSPs force you to convert the currency, but this is a small drag on returns.

    Other posts that might be of interest:
    http://canadiancouchpotato.com/2010/01/24/should-you-buy-us-listed-etfs/
    http://canadiancouchpotato.com/2010/10/18/are-us-listed-etfs-really-cheaper/

  3. J from Ottawa April 4, 2011 at 12:19 pm #

    I know your not supposed to time the market, particularly in a passive strategy, but US currency valuation swings back and forth over the years, at the moment it’s at par with the Canadian $, you can be sure the US dollar wll one day rise again and the Canadian $ will be at a discount, seems to me it’s a safe bet to buy Vangaurd in today’s market, if the Canadian $ loses value then perhaps you start buying the other.

  4. Canadian Couch Potato April 4, 2011 at 12:29 pm #

    @J: That may be true. However, the point I wanted to make in the article is that buying Vanguard’s international ETFs gives you no exposure to the US dollar.

  5. Doug April 4, 2011 at 5:14 pm #

    I have a spreadsheet that keeps track of our various accounts and have added a small section that keeps a tally of our exposure to USD, CAD and “other”(mostly Euro).

    I have set some very broad ranges for each of these around targets. The target was picked by imagining, or taking a best guess, as to where we would be most likely spending our retirement funds.

    We are dreaming of spending 3 or 4 months in the southern US or Mexico and, in a perfect world, a month or so in Europe. The targets are therefore roughly 30% USD, 10% Euro and the rest CAD.

    (If I recall correctly, this straightforward advice came directly from “martingale” either on the webring forum or efficientmarket.ca.)

    I have found this approach a big relief since it avoids any angst over what’s going to happen to the dollar. Just another way I suppose, to “set (re-balance as necessary) and forget”.

  6. gibor April 4, 2011 at 5:17 pm #

    “Others have taken the opposite view, arguing that now is a good time to buy these ETFs, because the US dollar is so low.” – I’m from this category , this is why I bought VEA and VTI and not Canadian equvalents…

    @CCP “If you hold XIN or a similar fund, the withholding tax is paid by the fund itself and subtracted from your return, even in an RRSP. It’s never recoverable.” – this is completely new for me :( . Do you mean if I have US ETFS in LIRA/RRSP – witholding tax is hidden, but i still pay it?

  7. Canadian Couch Potato April 4, 2011 at 5:45 pm #

    @Gibor: Buying VTI to take advantage of a low US dollar is fine, because VTI holds US stocks. But VEA is not cheaper when the US dollar is low. Sorry. This is a common error, which is why I wrote this post.

    If you have US-listed ETFs in a retirement account, then there is no withholding tax. The tax is only in effect if you have a Canadian-listed ETF that holds a US-listed ETF inside it, such as XIN or XSP. See this post by Canadian Capitalist:
    http://www.canadiancapitalist.com/how-withholding-taxes-affect-the-choice-of-international-investments/

  8. Simon April 4, 2011 at 10:06 pm #

    Just a friendly reminder – keep in mind the “no withholding tax” clause for US stocks/ETFs does NOT apply to TFSAs as it’s not a “registered retirement account”. So this policy will ONLY apply to RRSPs.

  9. Canadian Capitalist April 5, 2011 at 11:41 am #

    Call me a cynic but I think the reason why US funds don’t hedge currency is because foreign market returns have been boosted by the weakening in the US dollar for US investors.

    I wrote a detailed post on the currency effects of owning foreign stocks listed in US exchanges here:
    http://www.canadiancapitalist.com/currency-effects-of-buying-foreign-stocks-or-etfs-on-us-exchanges/

    Thanks for the mention!

  10. Hurler April 5, 2011 at 9:20 pm #

    For an US S&P 500 ETF- the option that I like for a CAD-Hedged US-Index ETF in Registered Accounts is HXS – which, as far as I understand, is currency hedged, but gives you the Total Return as a credit swap – thus no dividends are paid out (they are embedded in the total return). Thus, withholding tax is not charged. If you hold XSP instead, the withholding tax paid by the fund can never be recovered. True, it is a small amount – but paying unnecessary costs are anathema to the Couch Potato philosophy.
    Here’s hoping that Horizons can come up with a similar fund for International investments.

  11. Dong April 5, 2011 at 10:11 pm #

    I am personally a big fan of US ETF, especially from vanguard.

    They are ultra-low cost and as others said, with the dollars at par (near 1.04$ as i write this), its a no brainer. Look the 50+ years USD/CAD charts if you have doubts :)

  12. Canadian Couch Potato April 6, 2011 at 1:04 am #

    @Hurler: This is indeed a good option: in fact, the benefit of HXS is even larger in a taxable account, because there are no distributions at all: the only tax you pay are capital gains when you sell the fund.

    @Dong: Agreed, as long as you are talking about Vanguard ETFs that hold US stocks (as opposed to international stocks).

  13. Paul G. April 6, 2011 at 1:28 am #

    Here’s hoping HXS gets bit more of a following – it’s market cap of 170K$ isn’t exactly reassuring… nor is the fact that there’s hasn’t been a transaction in 3 full days. I know bid-ask spreads are what counts, but still… I find XCS a tad thin, so you can guess what I think of HXS – which otherwise is a perfect fit for me (will be used in a taxable account since my registered is filled up).

  14. Canadian Couch Potato April 6, 2011 at 8:32 am #

    @PaulG: I noticed those numbers for HXS as well, but they’re not accurate. I contacted Horizons who confirmed the following:

    The assets under management (AUM) on HXT was approximately $286 million as of April 1, 2011.

    The AUM on HXS was approximately $25 million as of April 1, 2011.

    Given that HXS is only a few months old, its small size is not surprising

  15. Chris Bowler April 6, 2011 at 9:36 am #

    I’m so glad to hear someone finally writing about this. I have speculated for a long time that it doesn’t matter what currency a given stock is traded in, what matters is the currency exposure of the operations of the particular business. For example, Intel (INTC) trades in US dollars, but has a significant percentage of sales and expenses in non US markets. Consequently I would expect even many US traded companies such as Intel are not as vulnerable to the US dollar as many believe.

  16. Open source portfolio April 8, 2011 at 1:44 pm #

    This issue with the withholding tax always confused me. Also I never understood why I don’t have to pay it within an RRSP but I do within a TFSA.

  17. Canadian Couch Potato April 8, 2011 at 1:49 pm #

    @Open source: Our tax treaty with the US is set up so that the withholding tax is waived for investments in “retirement accounts.” This includes RRSPs, RRIFs, LIRAs, and the like. TFSAs are not retirement accounts, so they are not included in the agreement. The same is true of RESPs.

  18. Soso March 1, 2013 at 12:09 pm #

    I know this is a old post. But I am still confused! If I undersand well CP, you prefer not to use hedging to $CAN. If this is the case, then why do you suggest using RBF559 instead of NBC839 in the internalional portion of the Global Couch Potato portfolio?

  19. Canadian Couch Potato March 1, 2013 at 12:26 pm #

    @Soso: It’s a good question. There is some convenience in using funds from the same family, since you can often use “switch” orders to rebalance, but I concede this is a small benefit. I should probably switch this recommendation when I next update the model portfolios.

  20. Soso March 1, 2013 at 12:39 pm #

    @CPP: thank you for your quick response. This clarifies the logic. I had been wondering about this for many weeks believe it or not. I became a DIY investor last October, I am still pretty confused on this kind of subjects. Your blog is my first source of information: I often need to re-read your posts many times before I understand what it is your are speaking about, so I thought I was just misunderstanding.

  21. Mark Candow January 13, 2014 at 5:53 pm #

    Hi,

    If I trade in CA$ and expect the value of the CA$ to appreciate vs the US$, it would be beneficial to buy the US version of a stock if it is traded on both the TSX and NYSE correct? Or does it matter because both versions of the stock will be purchased in CA$?

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