Last week I wrote about whether US-listed ETFs are really cheaper once you account for currency exchange fees, and then I looked at ways to reduce forex fees. The spreadsheet I created to compare US and Canadian ETFs allows investors to compare the costs using several assumptions.
One of those assumptions was to ignore currency hedging. Unfortunately, the reality is that the decision about whether or not to use hedging is likely to be the single most important factor affecting the return of your foreign investments. If the Canadian dollar moves up or down 15% over the period you’re invested, that will clearly have far more impact than a lower MER or a currency exchange fee. Too bad all we can do when it comes to currency fluctuations is guess.
Most Canadian ETFs with foreign holdings — notably XSP, XIN, CLU and CWO — use currency hedging. Not all of them do, however: unhedged international ETFs include the Claymore International Fundamental (CIE) and the iShares MSCI Emerging Markets Index Fund (XEM). Claymore also has an unhedged version of its US Fundamental Index ETF (CLU.C), though the trading volume is very low, attesting to just how unpopular the US dollar is with Canadian investors.
If you have a strong desire to eliminate currency risk from your portfolio, you’d be wise to use an ETF with hedging, regardless of the higher fees. (Note that the cost of hedging is only about 2 or 3 basis points annually, according to iShares. This cost is not included in the MER.)
For example, if you’re in your sixties and you plan to spend all of your retirement in Canada, you may well be wise to pay extra to hedge your foreign investments. Just keep in mind you could lose the bet: if the loonie fares poorly over the next decade, you would have done better with foreign currency exposure. However, you will have the assurance that a plunging US dollar won’t jeopardize your retirement, and there is some value in that.
If you’re investing for decades, however, I believe it makes little sense to place a bet on which way the dollar will go. It’s fashionable these days to say the US dollar is doomed, but investors have incredibly short memories. The loonie was worth $0.77 US as recently as early 2009, and it averaged about $0.63 US in 2002. Anyone who thinks the Canadian dollar can’t ever return to these levels is a foolish optimist. You may as well try to forecast what the winter in Calgary will be like in 2020.
It’s more reasonable to expect random currency fluctuations over several decades. Your best bet is to keep costs as low as possible and have exposure to foreign currency for its diversification benefit.
I can see the rationale for random currency fluctuations among developed countries, but shouldn’t there be a long-term appreciation in developing countries’ currencies relative to developed? If developing countries average annual growth 1.5 times higher than developed cohorts over the next decade or so, shouldn’t their currencies rise to reflect more capital channeled to these markets than flowing out and a larger increase in services/goods being purchased from these markets than the increase in goods/services sold to them?
@Bill: Interesting question. I don’t know the answer, but I will look into it and report back.
No reason you can’t hedge the hedge. My wife holds RBF558 (hedged) and I hold VTI. Our respective international index fund/etf are hedged but our emerging market ones are not.
I’ve seen some portfolios with a combination of hedged and unhedged positions. Perhaps that is one way to fine tune to risk preferences.
I’ve been following a Couch Potato approach using monthly contributions into an RRSP portfolio of TD e-Series funds for the last few years. For the US and International funds, half goes into the standard versions and half goes into the currency neutral funds. I can’t predict which way the dollar is going to go so this seems the best approach to me.
I, for one, got burned by currency fluctuations, mostly, because I was green and not watching close enough. Bought US stock, when the dollar was around 70 cents. The stock went up 30% but the dollar went up more. The moral, of course, is “pay attention”.
Long time reader, big fan.
I’m in the process of picking an ETF for US equity exposure, and finding it tough to thread the needle just right, as it were. While I started out expecting to largely compare MERs, I quickly ran into hedging, variations in yields, and tax treatments! While I feel I have somewhat of a handle on each of these in isolation, I’m struggling somewhat to find the best answers when factored in together. Some examples..
If I’m understanding the hedging issue correctly, it sounds like given ZSP vs ZUE (same holdings, MER, yield), then ZSP is the better choice so as to avoid hedging.
Bringing in yield, I see that CLU’s MER is higher but it also has twice the yield. While I realize yield shouldn’t necessarily be a deciding element (since its contributing factors can vary), it is hard to ignore as it appears to represent a substantial difference vs a ZUE/ZSP (and since the ETFs themselves appear to be a wash as they largely mimic each other). So the question is around yield and hedging, whether the better choice is a hedged CLU for its high yield, or a mid-yield non-hedged ZSP to avoid exchange rate drag?
Finally, I have seen your posts on HXT/HXS and they sound like interesting alternatives (I happen to be picking for an RESP so the tax work-around is of particular note). So the question is now around tax vs yield, whether the tax treatment of this (hedged) approach is beneficial enough to counter the higher yield of a CLU, and/or to counter the non-hedged ZSP?
Putting specific ETFs aside, and understanding that each of these factors themselves will vary over time, I wonder if you can provide any general insight or guidelines on how to conceptually bring all these factors together. It does seem like there are probably some triggers/thresholds in there that would tip the scales one way or another.
@Kieran: Thanks for the comment. With respect, I fear you’re overthinking this. I don’t even recommend ETFs for RESPs in most cases, since these accounts are usually small, and trading costs are likely to overwhelm the benefits of low-MER ETFs. This is certainly true if you are contributing monthly, or even quarterly. If it were me, I would pick a low-cost, unhedged S&P 500 index mutual fund and not worry about small details that will likely have no bearing on your education savings goal.
To address your specific question, yield is largely irrelevant unless you believe that dividend-paying stocks are likely to outperform the broad market over the long run. (This is opinion is widely held, but not by me.) Indeed, in an RESP, where you will pay withholding taxes on US dividends, higher yield is likely to result in lower after-tax returns. My recommendation in most cases is an unhedged, low-cost, broad-market fund.
Thanks for the response, and I think you’re almost certainly right about the overthinking. :)
I’ll add that I do also ask for my own (non-RESP) purposes, and so I wondered if broadly speaking there might be something buried in there somewhere that I wasn’t getting, but between your comments and some further research it doesn’t seem so. And case in point.. I have found that CLU seems to historically run roughly as far behind its peer ZUE as the dividend delta, except for the times when it runs ahead. And HXS seems to run about as far ahead of ZUE as the div delta, except when it runs behind. And in its short life, ZSP has run both ahead and behind these peers. All of which appears to prove.. well, nothing. :)
So many of your pieces are (rightly) about considering all the angles and making good choices, etc. It seems somehow disheartening to do the research and then basically throw a dart at the board and pick one. But I also get that you can only go so far, and then you need to choose and get on with it. (We’re also talking about markets here, so perhaps we have just reached the limits of applying rationality to a non-rational environment. :)
Thanks for your specific take on the RESP bit, I have seen some of your other pieces on this and am checking out some fund options as well. I realize I’m perhaps a bit over the top going with ETFs, however I’m with Questrade so get $4.95 trades (at the volumes I’ll be doing) with no annual fee, so even the TD eSeries funds barely look any better, and I haven’t yet seen any other attractive fund options.
Thanks again for your time, much appreciated.
@Kieran: Glad if I could help. I should stress I am not suggesting throwing darts when it comes to ETF choices. The specific funds in my model portfolios are carefully selected, and my list of recommended ETFs are also chosen for a reason.
Yes, with Questrade, you can make a much better argument in favour of ETFs. If you keep the number of trades to a minimum, your overall costs are likely to be a bit lower than with mutual funds. Good luck!
Ha, gosh no, I fully imagine you built your model portfolios and recommendeds with purpose and based on lots of research, and I have been using them as my starting point.
Though you hit on the crux of my point .. I meant the dart reference more specifically within a particular area, and in particular with US equities. I have reached a point where I have several options..
– generally similar in their core performance (HXS, CLU, XSP, ZUE, ZSP, etc)
– each with their own approach (some follow different indexes, HXS does no div and reinvests it directly, CLU pays out more as a net result than some of its peers, ZSP is non-hedged, etc etc.)
..yet I’m not able to successfully correlate these factors and choose the ‘best’ one; each factor seems to _not_ prove itself out. A simple example would be HXS.. I would have expected its approach to result in inherently better output/performance of the core stock, and while that is somewhat the case it is not consistently so; I may as well just buy ZUE, which is performing nearly identically while paying a 2+% dividend, no? And regarding yield, my question above was more around coming across ETFs with similar coverage, similar stock prices, yet varied yields.. ex. XSP and ZUE, which have nearly identical performance yet have slightly different yields. I presume since they are identical their share price should move in lock-step, which (if I have all that right) suggests that the ‘right’ choice is the one with the better net yield?
Perhaps we’re too far into the weeds again (and feel free to bail out if so), but I wonder if you can provide any more context on how you worked through these choices determine which was ‘best’ for your recommended choices?
@Kieran: The ETFs on my recommended list are chosen based on low cost, broad diversification, transparency (as few index rules as possible), a history of low tracking error, and tax efficiency.
I’m trying to decide among the following Vanguard funds:
– VOO – S&P 500 index traded on NYSE
– VFV – S&P 500 index traded on TSX
– VSP – Canadian-hedged S&P 500 index traded on TSX
These are all effectively the same index, but traded on different exchanges and with different currency exposure. It seems to me that the things to think about here are:
– currency conversion cost
– management costs
– currency fluctuations
Are there things I’m missing? I’m having trouble sorting out why I would want one versus the others.
@Robyn: You’re asking all the right questions. (One other factor is that VOO would be more tax-efficient in an RRSP, because you would be exempt from the withholding taxes on foreign dividends.) The decision comes down to which factors are most important in your situation. In general, if you can exchange US dollars cheaply, the US-listed funds are a better choice. But if your brokerage is gouging you on the forex, then a Canadian-listed choice will be cheaper.
If I think the Canadian dollar wil go down to around 85 – 90 cents US in the next 2 years or so …. what is the best way to play my hunch? Buy a hedged ETF? Can you name a few? Thanks
What is the most practical way once one starts getting close to drawing on there funds.
I mean we have anywhere from 3 to 7 or 10 etfs in various currency’s, countries etc.
It does not seem practical to draw down from multiple funds for cash to live?
I was thinking sell everything and go with a dividend fund and draw 4 percent or so a year, and forego the headache of selling off from a 1/2 dozen funds?
Great! I am facing difficulty to decide which ETF, hedged or unhedged for my RSP fund which will stay for another 10 years.
Canadian Couch Potato, I took your advice in this article about 3 years ago and bought VTI and CAD was at parity with USD. Thanks for that a lot! VTI has been the best performer in my RRSP portfolio. Also, it’s so tempting now to realize about 20% gain in USD by selling VTI and buying a hedged ETF. Would you advice against it? I still have about 20 years to hold the RRSP.
I am a newbie in the financial world and I am hesitating to hedge or not to hedge, namely my hesitation between either:
XUS or XSP (hedged). Which should I choose? The unhedged version receives a 5 star Morningstar rating, only 3 stars for the hedged version, wonder why? My investment is for 5 years or more. Any insights here?
@Denis: Morningstar ratings are effectively useless in evaluating index funds. In this case, XSP (hedged) gets penalized in their ratings simply because the Canadian dollar fell in value and therefore the fund underperformed its unhedged counterpart. Over the long-term, it generally makes sense not to hedge foreign currency exposure in an equity portfolio: