We’ve all been there before. A long awaited family trip to the U.S. quickly approaches, and we all suddenly become foreign currency speculators. If we wait too long, the U.S. dollar may appreciate against our beloved loonie, causing us to fork out more cash for travel expenses. If we convert our Canadian dollars too soon, we may stand idly by while our U.S. dollars quickly depreciate in the small beige envelope handed to us by the bank teller just a few days ago.
When we return from our trip, we’re delighted to see that we haven’t spent all of our U.S. dollars. We now have the difficult decision of whether or not we should convert the funds back to Canadian dollars. If the U.S. dollar appreciates relative to the Canadian dollar while the cash is gathering dust on our end table, this will allow us to convert it at a later date for more Canadian dollars than we originally spent to acquire them. If the U.S. dollar depreciates during this same period, we will receive less Canadian dollars when we eventually convert the funds. In essence, this is the same decision we are trying to make when deciding whether or not to hedge away our U.S. currency exposure with the use of currency-hedged ETFs.
Currency-hedged ETFs attempt to mitigate the negative effects a depreciating U.S. dollar can have on investment returns. As a result, it also eliminates the positive effect an appreciating U.S. dollar would have. This is why these products are also referred to as “currency-neutral”.
Disappointing Past Performance of U.S. Currency-Hedged ETFs
From January 2006 to December 2011, the U.S. dollar depreciated against the Canadian dollar by 12.8% (or 2.3% annualized). Over this same period, the S&P 500 Index (in USD) returned 2.3% annualized, while the S&P 500 Index (in CAD) returned -0.1%.
In theory, this time period would have been ideal for investing in U.S. currency-hedged ETFs. If we had made the decision six years ago to purchase the iShares S&P 500 Index Fund (CAD-Hedged) (XSP), we would have expected to see an annualized return before fees of 2.3%, similar to the returns of the S&P 500 Index (in USD). If we had instead decided to remain unhedged and purchased the iShares S&P 500 Index Fund (IVV), we would have expected a return before fees of -0.1%. The actual results of both strategies are illustrated in the table below.
Sources: BlackRock, BlackRock Canada, Dimensional Returns 2.0
Contrary to what we had expected, XSP did not outperform an unhedged strategy – it actually lagged the S&P 500 Index (in USD) by 2.4% annually. Although a portion of this underperformance could be attributed to management fees and withholding taxes, approximately 2.0% of the tracking error is still unaccounted for. If this 2.0% tracking error is an implicit cost of insurance for hedging away currency fluctuations between the U.S. dollar and the Canadian dollar, the additional drag may make it highly unlikely that a currency-hedged U.S. ETF will outperform an unhedged U.S. ETF over the long term.
Hypothetical Performance of Currency-Hedged Portfolios Relative to Unhedged Portfolios
If we look at how a perfectly hedged portfolio historically performed relative to a non-hedged portfolio, we would generally expect the hedged portfolio to outperform the non-hedged portfolio during periods where the U.S. dollar depreciated against the Canadian dollar. The moment we run the same analysis but subtract a fee from the U.S. index returns to represent the implicit costs of currency hedging, we notice an entirely different result.
Hypothetical Balanced Index Portfolios
1980-2011: Historical Periods of Outperformance (%)
Source: Dimensional Returns 2.0
As the investment horizon increased, the success of each portfolio depended less on whether or not the U.S. dollar depreciated against the Canadian dollar, but more on the tracking error subtracted from the returns of the S&P 500 Index (in USD). Interestingly enough, the U.S. dollar depreciated against the Canadian dollar over every 30-year rolling period. However, once the tracking error was taken into account, neither of the currency-hedged portfolios beat the non-hedged portfolio. There are a number of other issues to consider when deciding on whether or not to hedge your U.S. currency exposure.
Lower Historical After-Tax Returns in Taxable Accounts
U.S. currency-hedged products have historically been notorious for distributing significant amounts of capital gains to its investors, mainly due to the “rolling” of their forward currency contracts. From 2006 to 2011, a $100,000 investment in XSP would have received capital gains distributions totalling $16,654. Over the exact same time period, IVV distributed zero capital gains to investors.
Foreign Withholding Taxes in Non-Taxable Accounts
If an investor holds XSP in a non-taxable account (such as an RRSP), 15% of the distributions will be withheld (and cannot be reclaimed). When held in a non-taxable account, distributions from IVV will not have any tax withheld. From 2006 to 2011, an investor would have paid $1,409 of foreign withholding tax on their $100,000 investment in XSP.
Generally, an investor would want to hold stock ETFs and mutual funds in their taxable accounts whenever possible. This would allow the investor to take advantage of tax-loss harvesting opportunities. However, the potential for large capital gains distributions from U.S. currency-hedged products turns a relatively tax-efficient investment into a tax-inefficient one.
Currency-hedged products generally have higher management expense ratios than unhedged products. On the other hand, most unhedged products trade in U.S. dollars, so the cost of currency conversion can offset some of the benefit of a lower fee.
If you are an investor that frequents the U.S. to shop, it may be in your best interest not to hedge your U.S. dollar exposure.
Passively hedging your U.S. dollar exposure may not result in higher returns, before or after-tax (even during periods when the U.S. dollar depreciates relative to the Canadian dollar).