Living on the Hedge

Last week I discussed currency hedging as it applies to international equity ETFs. While iShares hedges currencies in its MSCI EAFE Index Fund (XIN), it does not do so with another of its popular international funds, the MSCI Emerging Markets Index Fund (XEM).

This fund holds stocks in more than 20 countries, and these are denominated in their native currencies: the Chinese renminbi, the Brazilian real, the Indian rupee, and so on. So Canadian investors will be exposed to currency risk with this ETF: if the loonie appreciates against any of these foreign currencies, the fund’s returns will be lower. If these foreign currencies strengthen, the returns of XEM will get a boost.

BMO’s entrant in this asset class, the BMO Emerging Markets Equity Index ETF (ZEM), also does not hedge currency and therefore has the same risk exposure. Not surprisingly, ZEM and XEM have performed almost identically.

However, the Claymore Broad Emerging Markets ETF (CWO) has blown away the iShares and BMO funds. Since November 2009, CWO has climbed more than 30%, compared with about 17% for ZEM and XEM. What’s the reason for this dramatic outperformance?

The weird world of CWO

Claymore’s CWO simply holds the Vanguard MSCI Emerging Markets ETF (VWO), which is traded in New York in US dollars. According to Claymore’s website, the ETF adds currency hedging “to reduce the direct exposure to non-Canadian dollar currency risk for unitholders of such fund.”

What isn’t clear from this explanation is that CWO’s hedging strategy is pegged to the US dollar, even though the underlying stocks are not denominated in US dollars.

As I explained in last Monday’s post, US-listed ETFs that hold overseas stocks do not expose Canadians to the fluctuations in the US dollar. Why, then, does Claymore use such a strategy? The reason is that the managers have designed this ETF so it will deliver the same returns for Canadians that its Vanguard counterpart will deliver to Americans.

To understand this point, imagine three investors:

  • Aaron is a Canadian who holds CWO. His ETF is denominated in Canadian dollars, and his returns are measured in Canadian dollars.
  • Betty is a Canadian who holds VWO. Her ETF is denominated in US dollars, but her returns are measured in Canadian dollars.
  • Carl is an American who holds VWO. His ETF is denominated in US dollars, and his returns are measured in US dollars.

Because of Claymore’s hedging strategy, Aaron and Carl will enjoy almost identical returns. Betty, meanwhile, will beat them both of them if the US dollar strengthens against the Canadian dollar, but lose to them both if the US dollar weakens.

I stress here that the currency hedging has no relation to the stocks in the fund. It is simply an active bet that the US dollar will decline against the loonie.

So far, so good

So far this gamble has worked out extremely well for CWO, because the US dollar has declined almost 17% against the loonie since the fund was launched in July 2009.

I’d be willing to wager, however, that only a tiny number of investors in CWO have the slightest idea how its hedging strategy works. Many probably selected CWO over its competitors because of its recent outperformance. But this outperformance cannot last indefinitely.

At some point, emerging markets are going to perform well during a period when the US dollar strengthens against the loonie. When that happens, investors in CWO will watch the value of their fund lag the index — and most will have no idea why.

It’s great that this hedging strategy has boosted returns for investors in CWO. But I have to question its logic. A Canadian who wants to invest in emerging markets shouldn’t be concerned with the strength of the US dollar versus the loonie. These are different investment risks that should have nothing to do with each other. CWO’s strategy makes as much as sense as buying an S&P 500 fund and placing a side bet on the Japanese yen.

I would love to hear from CWO investors who are learning about this for the first time: please add a comment below.

22 Responses to Living on the Hedge

  1. gil April 11, 2011 at 10:43 am #

    To hedge is to simply look at the inverse relationship of the US$ to CRB.

    If you go to stockcharts.com and enter $USD:$CRB, the graph tells it all.

    That why I was quite surprised when you didn’t hedge your global exposure.

  2. J from Ottawa April 11, 2011 at 12:26 pm #

    I’m quite sure your right, people buying the funds don’t really understand this, I certainly didn’t when I bought my first ETF’s, great series of articles, you’ve got a great blog.

  3. Canadian Couch Potato April 11, 2011 at 1:01 pm #

    @gil: I appreciate that there is historically a negative correlation between the USD and commodity prices, and that this relationship will have some bearing on the performance of an emerging markets fund. But this rationale is not explained anywhere in CWO’s literature. There is no way that most investors in CWO could even explain this concept, let alone cite it as a reason for investing in the fund.

    Let’s be clear: I’m not suggesting that people avoid CWO, only that they understand it before they choose which fund they want for their emerging markets position. I believe that ETF providers should be more transparent about their strategy or they risk becoming active managers.

    @J from Ottawa: Thanks for the kind words!

  4. Jim April 12, 2011 at 9:20 am #

    I am confused.

    You say, “So far this gamble has worked out extremely well for CWO, because the US dollar has declined almost 17% against the loonie since the fund was launched in July 2009.”

    If CWO is hedged against changes between the loonie and the US dollar, how can a decline in the US dollar vs. the loonie, boost returns of CWO? This seems like a contradiction.

    Your example of three investors also states that the American investing in US dollars gets the same return as the Canadian investing in CDN dollars. This backs up your idea that currency fluctuations between the loonie and the US Dollar are hedged, but it contradicts your assertion that CWO is doing better than the other ETF’s because it is hedged against the US dollar.

    If CWO is hedged against currency fluctuations between the loonie and the US dollar, how does a falling US dollar boost returns?

  5. Canadian Couch Potato April 12, 2011 at 9:38 am #

    @Jim: You’re not the only one who is confused! This is a convoluted arrangement. Maybe this will help clarify the idea:

    – Let’s start by thinking about an American who holds VWO. The stocks in VWO are denominated in their local currencies, so the falling US dollar has boosted returns for American investors. Meanwhile, in Canada, our strong dollar has lowered our returns in just about all international stocks, including emerging markets.

    – CWO is designed to deliver the same returns for a Canadian that VWO delivers for an American. So just as the falling US dollar benefits Americans holding VWO, it must also benefit Canadians holding CWO.

    – The proof is in the results: if you look at past returns of CWO (measured in Canadian dollars) and VWO (measured in US dollars) on Google Finance or some other chart, they overlap almost perfectly. Meanwhile, the returns of XEM and ZEM (as seen in the graph in the post) lag dramatically.

  6. Jim April 12, 2011 at 10:16 am #

    I think I get it now.

    The boost is coming from the US dollar declining against the other currencies the actual stocks are held in. So when that money is converted back to US dollars (which have declined), the overall return is boosted.

    Since CWO is hedged against the US dollar, this boost is passed on to holders of CWO.

    Since the CDN Dollar has held up better against those other currencies, a direct investment using CDN dollars does not get the same currency boost that the US dollars invested in those markets gets.

    This is an odd setup.

    Thanks for the response.

  7. Canadian Couch Potato April 12, 2011 at 10:21 am #

    @Jim: Yes, you’ve got it. It is indeed an odd setup – it’s worked out well so far, but we’ll see what happens over the longer term.

  8. GreenRookDebutant April 12, 2011 at 10:28 am #

    Ok, so what about the TD eSeries SP500 in USD (TDB902)? I’ve purchased the USD fund over the CDN $ fund due to the exchange. I figure when the loonie drops even by 10-15% I can sell the units, make 7-13% then buy the CND$ units and go on my merry way.

    Is there something I missed here?

  9. Canadian Couch Potato April 12, 2011 at 10:46 am #

    @Green: The TD fund you own holds US stocks and is not hedged, so you’re correct that if the US dollar strengthens you will get a boost in your returns. And, yes, you could then switch to the hedged version of the same fund and try to profit again if the loonie heads back up. Of course, that’s speculating, not investing. 🙂

  10. GreenRookDebutant April 12, 2011 at 10:56 am #

    Yes, speculating… but it’s not something completely out of this world. Unless of course we end up with an AMERO (North American currency) or a global currency some time soon. I think I should be ok at least until 2012. 😉

  11. gregmc April 26, 2011 at 4:22 am #

    Where can Isee whether an I-share ETF hedges the currency exposure back to USD (for US listed I-shares) or not ? I looked on the website for the Indonesia I-Share but I could not see anything.

    It’s quite a big factor in the invesment decision. You wold think they would make it very clear.

  12. Canadian Couch Potato April 26, 2011 at 9:24 am #

    @gregmc: As far as I am aware, iShares does not hedge currency in any of its US-listed ETFs.

  13. MyFairShare April 17, 2013 at 9:27 pm #

    Hello Canadian Couch Potato,
    I have only been “investing” for one year, and have been learning as I go along, by making mistakes in my Questrade account. (I can finally make decisions that are not based on fear, and hold stocks a bit longer.)
    Your blog contains the best information I have found so far, for explaining the difference between owning a $US Dollar position or a $CDN Dollar position in ETF.
    (I am Canadian – Toronto)
    I recently labored over my decision of weather to purchase a US ETF for Global Infrastructure, or a CDN ETF. I ended up purchasing the CDN CIF ETF: Claymore Global Infrastructure, only because it received 5 stars from Morningstar, and because I am not sophisticated enough to understand the effect that changing currency fluctuations have on the value of the funds. But I knew something was up, that I did not understand.
    If I understand you correctly, CGR, because it is purchased in CDN$, will benefit if the CDN$ becomes stronger than the US$?
    Also, I am holding off purchasing a Global REIT ETF, because I get nervous trying to figure out whether I should but a US$ ETF or a CDN$ ETF.
    So far, I keep returning to CGR iShares (Claymore) Global Real Estate Index. It seems to be the best access in CDN$, to global real estate.
    From what I can gather from your article, if the CDN currency strengthen, compared to the US currency, will this ETF do OK?
    ha ha ha, you can tell I am new to this.
    Plus, I get confused when I try to consider the other currencies in the other countries, even though I look up those countries in Morningstar and can read the list.
    Any feedback would be appreciated, as I still feel lost, and not able to make a wise decision.
    Thank you.
    MyFairShare

  14. Canadian Couch Potato April 17, 2013 at 10:53 pm #

    @MyFarirShare: No worries, this is a confusing topic and you’re not alone, but you’ve got it backwards. Your exposure is not to the currency the fund trades in: the expsoure is to the currency of the underlying holdings. CGR trades in Canadian dollars, but about half of the fund is in US stocks, so it will do well when the US dollar strengthens relative to the loonie.

    If you;re just getting started, I would encourage you to have a look at my model portfolios and just keep everything very simple.

  15. MyFairShare April 17, 2013 at 11:27 pm #

    OHHH, now I see through the fog.
    It feels much better to understand what I am getting into before I take the next step.
    Thank you.
    Cheers,
    MyFairShare

  16. dan lewinshtein July 10, 2014 at 4:04 pm #

    Dear couch potato,

    i am deciding between a US based ETF for emerging markets (VWO) vs. a canadian based (XEM).

    The american MER is much lower, and a contributing factor to why I would like to purchase it.

    I read your last article that I will not be exposed to currency risk to the US dollar, only to the underlying foreign currencies.

    My question: If I decide to sell the ETF at some point, the settlement will be in US dollars and if i want to convert that back to CAD then I will lose money, if the CAD has appreciated compared to the USD I assume…

    Thanks and I really appreciate your blog

  17. Canadian Couch Potato July 10, 2014 at 9:10 pm #

    @dan: No, you won’t lose money based on the CAD-USD exchange rate. If the CAD has appreciated against the US dollar during the period you held VWO, then each US dollar would be worth less, but you will own more of them. I realize this is confusing! I tried to explain the idea here:
    http://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/

  18. Chris September 16, 2014 at 7:54 am #

    Good Day Potatoes,

    Read this post as part of my decision as to what to do about hedged ETFs in my portfolio as I rebalance. I bought CWO a few years ago with only a vague understanding of how it would respond to exchange rate changes over time. I’m adding $$ to my portfolio and need to buy INTL equities in order to get back to target. XWD feels expensive right now, yet CWO is pretty reasonable, as are many emerging market ETFs. My question is: would anyone here take a deep breath and buy more CWO knowing exchange rates will probably flip again at some point, or would you dump CWO (at a small loss), and get into other non-hedged emerging market products?

    I know CP philosophy is to rebalance by selling the winners and buying more of the losers, but is this hedged ETF too risky?

    Thoughts?

  19. Bibi April 5, 2015 at 7:14 pm #

    Could somebody please explain to me… With a hedged ETF, I get protection from USD going down, but what if USD goes up? Is it true to say that hedged and unhedged ETFs will perform equally (minus the cost of hedging) if USD goes up?

  20. Canadian Couch Potato April 5, 2015 at 8:26 pm #

    @Bibi: If the USD goes up, the value of unhedged US equity ETFs would get a boost in returns compared with a hedged ETF. In the broadest terms, hedged ETFs do better when foreign currencies fall relative to the loonie; unhedged ETFs do better when the loonie falls.

  21. Bibi April 6, 2015 at 11:31 am #

    Thanks a lot for a quick reply!
    I read some of your other excellent articles. Now I see that I was wrong in my assumption. The way I understand it now is that a hedged ETF would have the “going up” dollar correction incorporated in the underlying stocks price and in this case the hedged ETF would report higher returns. An unhedged ETF would take that dollar correction out of the equation and report lower returns. Do I understand it correctly now?
    If yes, could you please answer my other question?
    I’m comparing VUS (hedged) and VUN (unheged) 1 year total returns as of close 31-03-2015:
    VUS NAV = 11.83%
    VUN NAV = 27.93%

    I used the following graph:
    https://ca.finance.yahoo.com/echarts?s=CADUSD%3DX#symbol=CADUSD=X;range=1y
    and changed From = 04/1/2014 To = 03/31/2015

    That gave me 12.79% CAD depreciation. Not sure if my math is correct, but 27.93 – 12.79 gives me 15.14%.
    MER of both ETF’s is the same and as far as I understand the hedging cost should not be as high as 3.31%.
    Is that what you call a tracking error?
    If yes, what could have been the reason for such an error?

  22. Canadian Couch Potato April 6, 2015 at 8:15 pm #

    @Bibi: For the correct way to do the math in this case, see the second half of this blog post:
    http://canadiancouchpotato.com/2011/04/07/a-case-study-in-currencies/

    An easier way to measure the tracking error of a hedged ETF is to look at the return of its US-listed equivalent. VUS should have a return equal to VTI, its underlying holding, minus about 12 bps for the difference in MER. In fact, VTI returned 12.31% over the year ending March 31, so the tracking error of VUS was 48 bps.

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