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.
{ 12 comments… read them below or add one }
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.
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.
@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!
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?
@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.
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.
@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.
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?
@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.
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.
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.
@gregmc: As far as I am aware, iShares does not hedge currency in any of its US-listed ETFs.