Currency Exposure in International Equity ETFs

My last post explained that Canadian investors are exposed to currency risk any time they hold US equities, even if their holding is an ETF or mutual fund that trades in Canadian dollars.

In my example, Gerry owned the Vanguard S&P 500 (VOO), which is listed on the New York Stock Exchange and trades in US dollars, while his wife Sharon owned the Vanguard S&P 500 (VFV), which trades on the TSX in Canadian dollars. Since the underlying holdings of both ETFs are the same—500 large-cap US stocks—both Gerry and Sharon have the same exposure to the US dollar, even though they’re trading in different currencies. (The exception would be if one chose an ETF with currency hedging, such as the Vanguard S&P 500 CAD-hedged (VSP), which is designed to eliminate currency risk.)

If that idea is confusing, it gets even more fun when you add international equities to the mix. Let’s say Gerry owns the Vanguard FTSE Developed Markets (VEA), an ETF that trades in US dollars and holds stocks from western Europe, Japan, Korea, Australia and many other overseas countries. Sharon owns the Vanguard FTSE Developed ex North America (VDU), the TSX-listed version of the same fund, which trades in Canadian dollars. Which currencies are Gerry and Sharon exposed to now?

Remember, your currency exposure comes from the fund’s underlying holdings, not from its trading currency. The stocks in VDU are denominated in a basket of overseas currencies: the euro, pound, yen, Swiss franc, Australian dollar, and others. So if the Canadian dollar appreciates against these currencies, Sharon’s returns will suffer, and if the CAD declines relative to them, she’ll get a boost. Easy enough so far.

But many investors are surprised to learn that Gerry has the exact same currency exposure as Sharon, even though his ETF is bought and sold in USD. The underlying holdings in VEA are exactly the same as in VDU, and the strength or weakness of the US dollar relative to the loonie will have no effect when Gerry calculates his returns in Canadian dollars.

A fair exchange

This is a confusing idea, so an example will help. Say you’re leaving for ski vacation in the Italian Alps when the euro (EUR) is worth $1.488 CAD, and the US and Canadian dollars are at par. The rates at the currency exchange counter look like this (assuming a spread of zero):

€1,000 EUR = $1,488 USD
$1,488 USD = $1,488 CAD
€1,000 EUR = $1,488 CAD

You have some US cash left over from your last trip to Florida and you decide to exchange $1,488 USD for €1,000 EUR before you leave for Italy. When you return to Canada a few weeks later, you notice the CAD/EUR exchange rate is the same, but the loonie has fallen to $0.92 USD. The sign at the foreign exchange counter looks like this:

€1,000 EUR = $1,366 USD
$1,366 USD = $1,488 CAD
€1,000 EUR = $1,488 CAD

Now if you sell €1,000 EUR for $1,366 USD, you’ll feel like you’re losing $122, because you paid $1,488 USD for the same amount on your departure. But in Canadian dollars, your €1,000 is still worth exactly the same. As a Canadian buying and selling euros, you don’t need to be concerned about the USD/CAD exchange rate. Even if you use greenbacks to make both transactions, the effect of the CAD/USD exchange gets washed out in the transaction.

Trimming the hedge

The same idea is at work if you buy international equities: if you’re thinking about selling VEA and buying VDU because the US dollar is high relative to the loonie, you’re wasting your money. Neither fund is affected by the USD/CAD exchange rate, and all you’re doing is incurring unnecessary transactions costs.

If you are worried about an appreciating Canadian dollar you could choose an international equity fund that use currency hedging, such as the Vanguard FTSE Developed ex North America CAD-hedged (VEF). If the loonie moves up against several foreign currencies at once, hedging would offer a significant benefit. But those periods of high correlation are relatively uncommon. During 2013, for example, the Canadian dollar declined against the euro, the pound and the Swiss franc, but appreciated against the yen and Australian dollar (see chart above).

This is why paying for currency hedging in international funds is a dubious strategy: to some extent the currencies hedge themselves and actually provide some diversification benefit.

31 Responses to Currency Exposure in International Equity ETFs

  1. will January 16, 2014 at 9:27 am #

    I’m still having a bit of trouble deciding whether to hedge or not.

    I certainly understand the diversity aspect, as well as the fact that MER’s are a bit lower as an argument for not hedging.

    However as somebody who plans to always live in canada and retire using canadian dollars it should make sense to switch to hedging at some point, especially near retirement right?

    I just find sometimes the currency stuff introduces a whole other mix of things to the portfolio mix that I don’t really have knowledge of or want to be exposed to, so hedging is tempting in that regard.

    I was also wondering if you could answer something for me about e-series funds (probably applicable to many others as well)

    the e-series US fund has a hedged, unhedged and US$ version.

    What are the differences with regards to currency hedging, especially with the US$ one? I assume its just the unhedged US fund held in US$, but what’s the point if you are already getting the dollar exposure as part of your underlying equities?

    Is it kind of like your explanation of the vanguard funds where people buy it in US$ thinking they are being smart, but really getting no difference at all?

  2. Brian S. January 16, 2014 at 10:08 am #

    This makes perfect sense if you are planning to convert your USD investments to Cdn. at some point (like retirement). But what if you are planning to spend considerable time in the USA? I think I may so I think like an American with my USD investments and don’t get too excited about currency movement.

    I’m not sure about my US investments in my RRSP though. I assume it is possible to convert the USD equities to a US MMF and then withdraw finds in USD by transferring them to my USD bank account.

  3. Willy January 16, 2014 at 10:50 am #

    @Will, understand your thought process completely, but I look at it this way. If the “stay in Canada” argument that you are making were valid then it follows that you should have 100% of your equity exposure in Canada as well. I bet you do not? Probably because you believe that Canada is a small market, and that you’d be missing significant greater exposure if that’s all you held. Is the currency issue not similar? Further, you no doubt have a plan to wind down your total (and international as well) equity exposure as you approach the time you need to begin drawing on your investments. If you hold unhedged international equity investments, your currency exposure will naturally be decreased at the same time by that same process.

  4. JSR January 16, 2014 at 11:47 am #

    “paying for currency hedging in international funds is a dubious strategy”

    Point taken for international ETFs that encompass a large diversity of currencies.

    I wonder, however, about hedging for US ETFs that hold US equities exclusively. If these hedged ETFs (say, VUS) hold the US stocks, you get the currency appreciation gain if the CDN$ goes down relative to the US$ and you are covered if the Canadian dollar appreciates against the US$. The same point would apply to an ETF that holds euro-stocks exclusively.

    By the way, I appreciate your willingness to explain these very basic ideas so clearly, since they are not that easily understood. I had just this discussion with my wife last night. She is a highly educated professional. It was a challenge, and I was happy to forward your post today!

  5. Canadian Couch Potato January 16, 2014 at 1:04 pm #

    @will: For a full explanation of the various TD US Index Funds, see this post:
    http://canadiancouchpotato.com/2010/08/11/will-the-real-sp-500-please-stand-up/

    @JSR: Thanks for the comment, and glad if this helps people understand what is really not that simple of a concept.

    Regarding hedging US dollars (or other currencies) when you have a short time horizon, I have heard this argument as well. But if you have a short time horizon, you should not be invested in equities, period. Equities are more volatile than currency, so if you are prepared to take equity risk you should be prepared for currency risk, too.

    The other issue to remember is that even if you plan to live and work in Canada, you still have indirect exposure to the US dollar, because many products we buy are priced in US dollars. (The USD historically has negative correlation with commodity prices.) So some exposure to foreign currency in an investment portfolio is probably always a good idea simply for its diversification benefits.

  6. Norman January 16, 2014 at 1:25 pm #

    It seems to me that tsx listed etfs such as vanguard still have relatively low volume. I understand volume of the etfs does not influence the bid/ask (it is the underlying volume of the stocks in the etf). However, I still notice that the bid/ask spreads of the low volume etfs are still greater. Also it takes longer to fill a position in low volume etfs.

    Is there any explanation for this?
    For this reason I still tend to buy us listed etfs (using norbits gambit).
    The us estate tax is a non issue since I am nowhere near the 5 million asset mark before this comes into play.

  7. pwt January 16, 2014 at 3:04 pm #

    One thing ive noticed over the years trading in USD exchanges for my ETFs is that any profits/losses from currency fluctuation are not tracked or recorded by my brokerage. For instance if VTI went up 10% and i profited another 5% on exchange rate and sold it all and gambited it back to CAD, my T5 only indicates the 10% gain. Is currency exchange profits tax free somehow?

    Its obvious to me that any canadian domiciled ETF would show the 10%+5% capital gain through NAV increase so those investors pay gains on currency based profits. why the disconnect?

  8. Canadian Couch Potato January 16, 2014 at 3:31 pm #

    @pwt: No profits are tax-free! When you calculate the adjusted cost base for the US-listed ETF, you need to include the currency conversion in the calculation and report the gain in Canadian dollars. The brokerage won’t do this for you. See pages 13-14 of our white paper on ACB tracking, which is linked in this post:
    http://canadiancouchpotato.com/2013/04/04/calculating-your-adjusted-cost-base-with-etfs/

  9. Canadian Couch Potato January 16, 2014 at 3:51 pm #

    @JSR: I meant to to address one of your other comments: “If these hedged ETFs (say, VUS) hold the US stocks, you get the currency appreciation gain if the CDN$ goes down relative to the US$ and you are covered if the Canadian dollar appreciates against the US$.”

    This implies you’re getting a free lunch. Yes, if you use currency hedging and the Canadian dollar appreciates, you’ve protected yourself from a loss. But if the CAD depreciates, you will give up a substantial gain that you would have enjoyed if you were unhedged. For example, VSP (hedged) returned 33% last year compared with 41% for VFV (unhedged). So there is always a tradeoff.

  10. JSR January 16, 2014 at 4:42 pm #

    Hmmm. Thanks for the clarification. My confusion here. I thought that if the hedged ETF holds the underlying US stocks in US$, then when the US$ appreciates relative to the CDN$, the CDN$ value of the hedged fund should increase accordingly. Not so, then? What assumption is wrong here? I am guessing that I am fundamentally uninformed about how currency hedged ETFs operate.

    Sorry if this sounds painfully uninformed.

  11. Canadian Couch Potato January 16, 2014 at 5:38 pm #

    @JSR: “I thought that if the hedged ETF holds the underlying US stocks in US$, then when the US$ appreciates relative to the CDN$, the CDN$ value of the hedged fund should increase accordingly.” No, it’s the other way around. If the USD appreciates, the unhedged fund would do better. The hedged fund helps you when the Canadian dollar rises (and therefore the underlying foreign currency goes down).

  12. taran January 18, 2014 at 11:18 pm #

    Thanks for the post. As i have some cash GBP, i was waiting for CAD to go down further before transferring and investing. I realize it was a mistake, had i invested my money in USD etf last year i would have taken advantage of falling CAD regardless

  13. Jeff January 19, 2014 at 7:25 am #

    Hey CCP,

    Just wanted to get your opinion on dealing with currency fluctuations strategy with respect to company valuation and ultimately stock price with respect to revenue sources. For example, if I buy shares of ford, and the value of the US dollar depreciates against various currencies, such as the CAD, my CAD market value will drop, however this will be offset by the company possibly generating more revenue and profit from a weaker USD as their revenue comes from other currencies which could then ultimately increase the share price, and thus offsetting some of the direct currency loss in my portfolio. The extent of this effect obviously depends on the proportion of foreign source income, but ultimately it further complicates the process of thinking about our decisions when trying to offset our own currency risk.

    Anyways, just want to get your thoughts.

    Thanks

  14. Canadian Couch Potato January 19, 2014 at 9:21 am #

    @Jeff: Michael James wrote an interesting post that touches on this topic:
    http://www.michaeljamesonmoney.com/2014/01/currency-exposure-is-partly-illusion.html

    I don’t think the situation needs to be actively managed with a specific strategy: I can’t imagine that it’s something within an investor’s control. And for an index investor (who doesn’t spend time worrying about a specific company’s exposure to foreign source income) it’s essentially addressed by diversification across thousands of foreign companies.

  15. Jerry January 22, 2014 at 6:49 am #

    Perhaps slight thread drift here but bear with me: I have a sum in the high six figures in USD which I need to get into the market. Is there any advantage in opening a brokerage account in the USA and conducting operations there or should I just employ the money using my existing Canadian broker and whatever he can offer in the way of USD-nominated funds?

    Thanks again for the immensely valuable help you have provided over the last year(s)…

  16. Edwin January 22, 2014 at 1:52 pm #

    Could you comment on the pros / cons of exposure to only International holdings versus exposure to both International & Emerging Markets (i.e. 30% XEF vs. 15% XEF + 15% XEC)? Most model portfolios just have a general 20-25% for International holdings.

  17. Canadian Couch Potato January 23, 2014 at 12:15 am #

    @Edwin: Emerging markets represent about 10% of the global market, and they are not highly correlated with developed markets, so they offer some diversification benefit. But if the portfolio is relatively small I would consider them optional. Canadian, US and international developed markets provide plenty of diversification on their own.

  18. Canadian Couch Potato January 23, 2014 at 12:21 am #

    @Jerry: Unless you are a US resident you’re unlikely to be able to open a US account, and the tax implications would be onerous. There are plenty of opportunities to invest with USD in a Canadian brokerage.

  19. Michael February 1, 2014 at 7:46 am #

    “But if you have a short time horizon, you should not be invested in equities, period.”

    Really? How about negatively correlated equities?

    Maybe you are saying that for a short time horizon one is speculating rather than investing.

  20. Mark March 10, 2014 at 2:23 am #

    I am having difficulty getting my head around this and would appreciate the clarification.

    My portfolio is based in USD but I own stocks in several Canadian funds including (VCE and XBB). When I bought the funds over a year ago, the USD and CDN were on par for each other. However, now my total P/L through my brokerage reports a massive loss in USD (even though some of the funds have actually increased in growth). I assume this is due to the depreciation of the CDN (around 0.89 now).

    So haven’t I effectively lost money since my funds were more expensive a year ago then they are now (assuming I sold everything)? I was told that the currency fluctuation are built into the fund but this doesn’t seem to be the case. How does this work? Please help!

  21. Canadian Couch Potato March 10, 2014 at 9:21 am #

    @Mark: I’m a bit confused by your comment that your portfolio is “based in USD” but you hold VCE and XBB. Can I assume you’re a Canadian but you’re living in the US and brokerage that reports its returns in American dollars? If so, then you’re essentially in the opposite situation of a Canadian buying VTI or other US-listed ETFs through a brokerage that reports in Canadian dollars. In your case, VCE is subject to currency risk: as measured in US dollars, its recent performance may indeed have been negative because the Canadian dollar has declined. This sort of thing is par for the course if your are invested in global equities (it’s only been one year).

    What’s more concerning is your holding in XBB. It is generally not a good idea to take any currency risk in your fixed income holdings, since these are supposed to be the stable part of your portfolio. If you are earning US income and your future liabilities are in US dollars you may want to consider using a US-denominated bond ETF instead.

  22. Mark March 10, 2014 at 10:40 am #

    Yes, you are correct in your assumption as I’m an expat Canadian. My brokerage account is in USD so whenever I buy anything through the TSE, I need to convert my USD to CDN (and vice versa if I sell).

    Your response made me feel a little better as I realized my problem early as well with the fixed-income bit and I have now balanced my portfolio with an equal amount in BND. Do you think it is better to continue with this strategy to offset any additional currency risk in the future or not carry any Canadian fixed income at all?

  23. Canadian Couch Potato March 10, 2014 at 11:06 am #

    @Mark: I can’t advise you on what would be appropriate in your circumstances. It really depends on whether your future liabilities will be in USD or CAD. But I will mention that you don’t need to convert USD to CAD in order to buy Canadian equities. You could consider the US-listed iShares MSCI Canada (EWC):
    http://us.ishares.com/product_info/fund/overview/EWC.htm

    Horizons also has a US-denominated version of HXT:
    http://www.horizonsetfs.com/pub/en/Etfs/?etf=HXT.U&lang=en

  24. sat March 11, 2014 at 10:59 pm #

    I am starting building my portfolio. I am having quite higher income than my wife. I have room in (spousal) RRSP @ $22000 and TFSA @ $31000. I want to invest in aggressive ETF because I have @ 20 years to retire. I am thinking to put in VCN, VUN, XEF, please suggest me, how should I distribute @ $50000 in those ETF.
    Do you think I should also invest in emerging market too. Which ETF is good for that.

  25. sat March 11, 2014 at 11:01 pm #

    Is it good time to invest in those ETF’s now. Do you think it there any effects of ukraine crisis

  26. Garret March 12, 2014 at 9:47 am #

    Thanks for the great article. I wish I could wrap my head around the implications.

    I’m similar to Mark. I’m a dual Canadian-American citizen living in China, but earning CAD. I’m in my early 30s, so I have many years to retire and have no idea where in the world I might retire.

    Any advice on how I could go about choosing whether to buy in CAD. As I understand it, buying in CAD avoids exchange rate loss, but has hedging fees which I might never use (and is incurred every year). Buying in USD pays exchange rate, has no hedging loss, but I then pay withholding tax on dividends.

    Maybe the best option is the spread part in USD, part in CAD. But the Canadian dollar is low now, so it seems a waste to convert to USD now, but that also sounds like trying to time the market. Not trying to time the market is exactly why you buy ETFs in the first place. All this makes my head spin.

  27. David April 12, 2014 at 8:09 pm #

    Related to Garret’s question…

    If the scenario is that all income is in CAD and my liabilities is in CNY (Chinese Yuan), e.g. a retiree living in China. What’s a reasonable approach to protect against currency risks in the Bond portion of the portfolio.

    My understanding is that Bonds should be bought in the place you live and spend money. There doesn’t appear to be a CAD-hedged China bond fund.

  28. Canadian Couch Potato April 13, 2014 at 12:40 am #

    @David: I can’t offer any useful advice for someone in your situation, but in general, if you want to hold bonds “in the place you live and spend money” and that place is China, then you would not want a CAD-hedged China bond bond. You would would want unhedged exposure to Chinese bonds. Unfortunately I have no idea how you might get that exposure.

  29. Bibi April 6, 2015 at 1:50 pm #

    Thanks for another great article!

    Would you still suggest to have VEU in an RRSP account? I read in one of your articles that in this case withholding taxes could be an issue because only US tax will be waved but other countries will not.
    With the same regard to withholding taxes, will having VDU make any difference since its sole holding is VEU?

  30. Canadian Couch Potato April 6, 2015 at 8:09 pm #

    @Bibi: There is no way to avoid international (non-US) withholding taxes in an RRSP. But overall, VEU would be more tax-efficient in an RRSP than VDU:
    http://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/

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