How have international equities performed over the last year? If you research the returns of index funds in this asset class, you may wind up with more questions than answers.

I recently received an email from David, a reader who wanted to know why the recent performance of three international equity index funds looked so different. It’s an excellent question, because unless you understand what’s going on here you’re liable to make a poor decision when choosing one for your portfolio. Exhibit A, their returns over the last year (period ending December 4), according to Morningstar:

TD International Index Fund – e (TDB911) 7.66%
iShares MSCI EAFE Index ETF (XIN) 10.21%
iShares MSCI EAFE ETF (EFA) 1.80%

All of these funds have the same benchmark: the MSCI EAFE Index, which covers developed markets outside North America, including Japan, Europe and Australia. In fact, XIN uses EFA as its sole underlying holding, so the two funds have identical stock exposure. Why, then, is their performance dramatically different?

Peeking over the hedge

Let’s begin with the TD International Index Fund, which simply holds all 900 or so companies in the index and reports its returns in Canadian dollars. Investors in this fund are fully exposed to the currency of the underlying stocks. If the yen falls relative to the loonie (as it did this year), Canadian investors will see the value of their Japanese stocks decline. On the flipside, if the British pound rises (as it has in 2014), Canadians will get a boost in the return of the UK stocks in this fund.

The iShares MSCI EAFE Index ETF (XIN) holds the same stocks, but its exposure is fundamentally different. This ETF uses currency hedging to try and remove the effect of foreign exchange rates. So if Japanese stocks go up 5% in their local currency, Canadian investors should also expect a 5% return, regardless of whether the yen gained or lost value relative to our dollar.

This difference in currency exposure explains why XIN outperformed the TD International Index Fund by over 2.5% during the last 12 months. Most international currencies depreciated relative to the loonie this year, which caused unhedged index funds to lag. In years when the Canadian dollar is weak versus overseas currencies, the unhedged fund should be expected to outperform.

And what about the iShares MSCI EAFE ETF (EFA) and its dismal 1.88% return? This ETF is listed on a New York exchange, so its returns are reported in US dollars. Like the TD International Index Fund, EFA does not use hedging, so US investors are exposed to currency risk when they hold this ETF. The US dollar had a big year in 2014: it appreciated against the yen, euro, pound, Australian dollar and the Swiss franc. The result was a huge drag on returns for investors who measure their returns in greenbacks.

Your money’s no good here

There’s one more layer to this story, and it’s important for Canadians who use US-listed ETFs for their international equity exposure. Although funds like EFA are bought and sold in US dollars they do not expose Canadians to that currency. If you held EFA or a similar fund in your account, you did not suffer as a result of the US dollar’s climb this year. If you measure your returns in Canadian dollar terms (as you should), your holding in EFA would have performed very similarly to the TD International Index Fund. You would have seen a gain of more than 7% over the last 12 months.

So which of these funds is best for your portfolio? Although it has worked well recently, I believe you should avoid currency hedging in foreign equity funds. It’s expensive, not very precise, and there is good evidence that currency exposure actually lowers risk for Canadian investors.

The choice therefore comes down to whether you should use an unhedged index fund or ETF domiciled in Canada or the US. (The TD International Index Fund is just one of many offering similar exposure: others include unhedged ETFs from iShares, BMO and Vanguard.) For most investors—especially those investing in non-registered accounts or TFSAs—the Canadian option is preferable, as it allows you to avoid the cost of trading in US dollars. For RRSP investors who want to keep costs and foreign withholding taxes to an absolute minimum, a US-listed ETF may be a better choice.