In this final post in the series on why international index funds performed so poorly in 2009, it’s time to look at currency hedging.

Currency hedging is a strategy designed to smooth out the fluctuations in the value of the Canadian dollar relative to other world currencies. For example, in a fund that tracks the EAFE index (which covers Europe, Japan and Australia), the stocks are denominated in pounds, euros, yen and Australian dollars. If the UK holdings go up 10%, but the loonie rises in value by 4% relative to the British pound, an investor’s return in Canadian dollars is only 6%. To protect against this potential loss, a fund can buy forward contracts designed to offset the currency swings. Ideally, Canadian investors in a hedged EAFE fund should receive the full 10% return of their UK stocks. (If you’d like to learn more, RBC offers a nice explanation of currency hedging.)

It’s a reasonable strategy: if all of your liabilities are in Canadian dollars, it makes sense to hold your assets in Canadian dollars, too. Yesterday’s guest post on Canadian Capitalist also makes a compelling argument that currency hedging reduces volatility for investors with foreign holdings. Others argue that currency swings go both ways and should even out over the long term, and besides, a bit of foreign currency in your portfolio adds diversification.

But leave aside the hedge-or-no-hedge debate for now. Let’s instead ask whether the strategy does what it’s supposed to do. In international index funds in 2009, at least, the answer was a thunderous no.

Exhibit A is the iShares MSCI EAFE Index Fund (XIN), which lagged its index by 5.34% last year, by far the highest tracking error of any iShares ETF. The US-listed version of this fund (EFA) tracked the index perfectly, so the performance drag was almost entirely due to the hedging strategy. Claymore’s Japanese Fundamental (CJP), emerging markets and US funds also had large tracking errors, partly due to hedging. Bottom line, Canadians looking for — and paying for — protection from a rising loonie didn’t get it.

That shouldn’t be surprising. As Rob Carrick writes, “Hedging is like playing hockey with a baseball bat. It can be done, but the results are clumsy.” Both iShares and Claymore explained to me that they reset their hedges every month, but the indexes are adjusted daily. Between reset dates, if the stock market moves dramatically, or if the fund experiences a large inflow, some foreign currency can be left exposed.

Here’s how: assume that on the first day of the month a fund holds European stocks valued at  €100 million and the manager buys a forward contract covering that amount. Over the next couple of weeks, the market surges and the stocks are now valued at €107 million. Giddy investors start pouring money into the fund and soon it holds €112 million worth of equities. But the currency hedge covers only €100 million. So now, if the euro moves up or down before the month is over, €12 million will be affected by these fluctuations. That can open a wide gap between the fund’s performance and that of the index.

Hedging can be even more ham-fisted: Claymore’s emerging markets ETFs (CBQ and CWO) are hedged against the US dollar, but the underlying securities are denominated in Chinese yuan, Brazilian reals, and a host of other currencies. This is called a proxy hedge: Claymore is assuming that the US dollar will move in concert with emerging markets currencies, which are too difficult to hedge directly. However, Canadian Financial DIY has pointed out that this assumption doesn’t hold up to scrutiny.

Finally, currency hedging ain’t cheap. Buying and selling forward contracts adds frictional costs to the fund. (iShares estimates that it results in a drag of about 0.15% annually.) That might be worth it if the strategy delivered what it promised. But over the last few years, the record of currency-hedged funds has been disappointing, to say the least. Unless it improves, I’ll continue to recommend that Canadians get their international equity exposure through US-listed ETFs from Vanguard and iShares.