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Decoding International Equity ETF Returns

2017-12-02T21:39:52+00:00December 5th, 2014|Categories: Foreign currency, Index funds|Tags: |7 Comments

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.


  1. Paul G December 5, 2014 at 1:02 pm

    Don’t we lose withholding taxes in an RRSP for all ETFs with non-American (or Canadian!) equity ? (thinking of VXUS – which is domiciled in the US but the underlying properties aren’t American)

  2. Canadian Couch Potato December 5, 2014 at 1:41 pm

    @Paul G: Yes, you still lose the withholding tax in an RRSP, but it is likely to be less with US-listed ETFs. With some Canadian ETFs (such as XIN or VDU) there will be two levels of withholding tax because of the “wrap” structure. And even with XEF or ZEA, which hold the stocks directly, the withholding taxes are generally higher in Canadian funds than in US funds because of the different tax treaties with overseas countries.

  3. David December 5, 2014 at 2:40 pm

    Dan, is your Global Couch Potato XEF hedged or unhedged?

  4. Canadian Couch Potato December 5, 2014 at 3:05 pm

    @David: XEF is unhedged.

  5. TJ Machado December 5, 2014 at 8:37 pm

    International funds are best purchased from Canadian providers who buy the securities directly – as opposed to a fund of funds model. That way you get a credit for the foreign withholding taxes.

  6. Cam December 7, 2014 at 10:52 am

    Newbie here, so forgive me if I’m completely off base. I’m not sure I understand how unhedged ETFs are good for long term investments (10-20 years). Aren’t you banking on the relative strength of Canadian dollars to foreign dollars to be in your favour when it comes time to sell? Another way to phrase the question: with the fluctuations in relative currency values, how do you plan your exit strategy for selling unhedged ETFs without getting hurt by a strong Canadian dollar or weak Euro/yen/pound/etc?

  7. Canadian Couch Potato December 7, 2014 at 11:02 am

    @Cam: Thanks for the question. There is no reason to believe that anyone knows what the relative strength of any currency will be over the long term. Therefore, in theory, there is no way to know whether going hedged or unhedged would lead to higher expected returns. But that assumes that hedging is free and precise, and it is neither. Over the medium to long term, currency hedged ETFs have tended to lag their own benchmarks, often significantly.

    Remember, too, that most investors’ “exit strategy” is the gradual drawing down of their portfolio during a retirement that may last several decades. So you are not making an active bet on where any currency will be at a specific point in the future.

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