Archive | Foreign currency

Decoding International Equity ETF Returns

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,

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The Couch Potato Goes Abroad

Andrew Hallam’s Millionaire Teacher remains one of the best introductions to index investing. When I reviewed it three years ago, I stressed that Andrew writes with authority because he follows his own advice.

In his new book, The Global Expatriate’s Guide to Investing, Andrew shares more of his first-hand knowledge about managing an indexed portfolio outside your home country. Andrew left Canada in 2003 and spent years as a teacher in Singapore before settling (at least for now) in Mexico earlier this year. So he knows all about the challenges—and the surprising benefits—of being an expat investor.

Most of his book’s advice applies equally to homebodies: the first several chapters lay out the case for using a passive strategy, whether with plain-vanilla ETFs, a fundamental index strategy, or the Permanent Portfolio. Then he explains how expats can put these ideas into practice. I asked Andrew to elaborate on some of the key points for Canadians living abroad.

What are the most important tax issues that Canadian expat investors need to be aware of?

AH: So much depends on where the expat is living.

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Why Currency Hedging Doesn’t Work in Canada

In the last two years, Canadian ETF providers have finally launched US and international equity ETFs that do away with currency hedging. Yet the strategy remains hugely popular: the hedged versions of Vanguard’s international and US total market ETFs remain much larger than their unhedged counterparts, while investors have more than $2 billion in the iShares S&P 500 Hedged to CAD (XSP), making it the third largest ETF in Canada.

None of my model portfolios include currency-hedged funds: I’ve long argued the strategy is expensive and imprecise. Even when the Canadian dollar appreciates strongly, the high tracking error of currency-hedged funds often reduces any potential benefit. In one dramatic example, Justin Bender looked at the period from 2006 through 2011, when the US dollar depreciated by almost 13% and hedging should have produced a huge boost: in reality, XSP lagged its US-listed counterpart.

This leads to an interesting question. If currency hedging were free and precise—with an expected tracking error of zero—would it be worth considering?

Does hedging lower volatility?

The most common argument in favour of currency hedging is that it lowers volatility.

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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.

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How a Falling Loonie Affects US Equity ETFs

Over the last year the loonie has declined significantly relative to the US dollar: the currencies were at par early last February, but the Canadian dollar closed under $0.92 US on January 10. That has been a benefit for Canadians who hold US equities: not only did the stocks deliver huge returns in their local currency in 2013, but we got a further boost thanks to the appreciation of the US dollar.

Unfortunately, the drop in our dollar has encouraged some ETF investors to attempt to exploit a buying opportunity. Trying to make currency plays is foolish at the best of times, but it’s especially unwise if you don’t fully understand how currency exposure works.

Meet Gerry, who uses the Vanguard S&P 500 (VOO) to get exposure to US stocks. This ETF is listed on the New York Stock Exchange and trades in US dollars. With the greenback riding high, Gerry plans to sell VOO and use the proceeds to buy an equivalent fund listed on the TSX: the Vanguard S&P 500 (VFV). Gerry tells his friends he’s selling US dollars high and buying Canadian dollars low while keeping his equity exposure the same.

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Ask the Spud: When Should I Use US-Listed ETFs?

Q: Under what specific circumstances would it be better to hold a US-listed ETF if there is a Canadian equivalent? For example, when it is preferable to use the Vanguard Total Stock Market (VTI) rather than the Vanguard U.S. Total Market (VUN)? — R. F.

Until late 2012, there really were no great options for Canadian ETFs that held US and international equities. If you wanted a low-cost, cap-weighted index fund that did not use currency hedging, you were out of luck. That’s why my Complete Couch Potato model portfolio currently uses a pair of US-listed ETFs for its foreign equity components.

But the case for using US-listed ETFs is not nearly as compelling as it used to be. Since April, iShares and Vanguard have launched inexpensive Canadian ETFs covering the broad US and international markets without currency hedging. For example, the Vanguard U.S. Total Market (VUN), launched in August, is virtually identical to the Vanguard Total Stock Market (VTI)—indeed, VUN simply holds units of VTI.

There are three important differences between these ETFs,

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Norbert’s Gambit: The Complete Guide

Norbert’s gambit remains the least expensive way to convert Canadian and US dollars at a discount brokerage. For investors looking to buy US-listed ETFs, learning this technique can save hundreds of dollars by sidestepping the wide currency spreads charged by brokerages.

With the 2013 launch of excellent unhedged foreign equity ETFs from Vanguard and iShares, there’s less of an incentive to use US-listed ETFs than there used to be. In fact, in a non-registered account or a TFSA it may not even be worth the added cost and inconvenience if the only difference is a few basis points of MER. But in an RRSP, there’s a significant benefit: using US-listed ETFs can dramatically reduce the impact of foreign withholding taxes, which can add an additional cost of 0.30% to 0.70% to US and international equity holdings.

The problem with learning to pulling off Norbert’s gambit, however, is that there’s no simple set of instructions that works at every brokerage. RBC Direct Investing and BMO InvestorLine both allow you to hold US dollars in registered accounts, but only RBC allows you to do Norbert’s gambit online: at BMO you need to pick up the phone.

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Inside the New Vanguard ETFs

Vanguard Canada launched some new ETFs this week, and I spoke with managing director Atul Tiwari about the funds. Let’s take a closer look.

Cross-Canada coverage

The Vanguard FTSE Canada All Cap (VCN) expands on the older Vanguard FTSE Canada (VCE). While VCE holds 78 large-cap stocks, the new index includes 255 holdings and covers 96% of the Canadian equity market. That makes it roughly equivalent to the S&P/TSX Composite Index, which holds 234 companies and claims 95% coverage.

This is about as close as you can get to a total-market index in Canada: dig further and you run into serious liquidity problems with small, thinly traded stocks. “We started out with a very large universe and pared it back to a number we thought would be terrific,” Tiwari explains. “But once you get to the practical aspects it gets pretty tough. Our partners on the capital markets side, who are creating units and doing the market making, have to be comfortable they can find these securities. Obviously there’s a cost associated with that, and at some point it gets too unwieldy and it doesn’t make sense.”

With a management fee of just 0.12% (the MER will be a few basis points higher),

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Norbert’s Gambit at CIBC: A Case Study

Norbert’s gambit is an excellent way to reduce the cost of converting Canadian and US dollars, but not every brokerage makes it easy. Recently Justin Bender helped a client of our DIY Investor Service with a large currency conversion inside an RRSP at CIBC Investor’s Edge. It saved the client hundreds of dollars, but it was a complicated transaction and we thought other CIBC investors would benefit from learning the steps.

The difficulty stems from the fact that CIBC does not allow you hold US dollars in registered accounts. Whenever you buy or sell US-denominated securities, the brokerage forces you to convert the currency with the usual spread.

In the example below, the goal was to convert approximately $100,000 CAD to the equivalent in USD, and then use the proceeds to purchase a US-listed ETF. The prices and exchange rates were current at the time Justin made the transactions. For simplicity, we’ve rounded some numbers and ignored the $6.95 trading commission that applied to each trade.

Step 1

When doing Norbert’s gambit, we use the two versions of the Horizons U.S.

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