# XSP (hedged S&P 500) tracking and drag



## james4beach (Nov 15, 2012)

XSP is the TSX traded S&P 500 Index Fund (CAD-Hedged). The idea with this is supposed to be that, due to the currency hedge, the performance of XSP should be the same as the S&P 500 index. That is, if the S&P 500 goes up 10% then XSP should also go up 10%, no matter what the exchange rate does.

It was observed before, even CanadianCapitalist had an article I think, that there is a drag (essentially a "cost of the hedging"). I wanted to revisit the current effect of the drag. Could someone help, am I looking at this properly?

First I pulled up the American IVV performance page, as this is the underlying native index fund that XSP simply wraps around. IVV performance as of 9/30 was
YTD.... 19.74
6 mo... 8.28
1 yr... 19.28
3 yr... 16.17
5 yr... 9.96
10 yr.. 7.50

Then I pulled up XSP NAV performance, also as of 9/30
YTD.... 19.72 .. -0.02%
6 mo... 8.30 ... +0.02%
1 yr... 19.43 ... +0.15%
3 yr... 15.65 ... -0.52%
5 yr... 7.49 .... -2.47%
10 yr.. 4.54 .. -2.96%

Is this a valid comparison? These should be very close, ideally. I'm noticing that within 1 year, it looks great. Even up to 3 years that's very good tracking -- currency hedging must really be doing its job well.

Then something appears to happen going back 5 years or more and a huge drag appears.

Thoughts about all this? Has XSP gotten better, in recent years, at perfectly hedging away currency?


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## humble_pie (Jun 7, 2009)

good observation, thankx

my hypothesis: the figs show CC's fathomless power to influence the financial industry for the better. He had only to call attention to the tracking loss & presto they cleaned up their act ...


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## GoldStone (Mar 6, 2011)

XSP changed its mandate in 2005. It didn't hedge the currency before the change. Also, it used futures contracts rather than direct holdings, to circumvent the old foreign content RRSP limit. Once RRSP limit was lifted, they introduced the hedging to differentiate themselves from the cheaper US ETFs.

http://web.tmxmoney.com/article.php?newsid=3147643&qm_symbol=XSP


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## CanadianCapitalist (Mar 31, 2009)

You are going to see delta between XSP and IVV. That's the nature of hedging. I've looked at XSP versus IVV over the years and you'll see significant differences in years the currency moves in opposite direction to the stock market.

http://www.canadiancapitalist.com/performance-of-currency-neutral-sp-500-index-funds/

Also, as Goldstone points out, you should look at differences from 2006 onwards. Before that XSP was a so-called "clone" fund that used to be a popular way to skirt RRSP foreign content rules.


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## james4beach (Nov 15, 2012)

OK thanks for reminder about 2006 onwards... so disregard the "10 year" numbers in my post.

Thanks CC that was the article I was trying to find. Great stuff! Comparing the same things, but I prefer your year-by-year comparison and it really does show, as you say, the significant differences between the years.

So although the drag has lessened and the last year(s) look particularly good, it could just be as a result of the current forex direction (and I'll suggest low volatility too). You've shown there that the average annualized drag over the years is 2.1%... yikes.

That's a pretty big delta. I knew there was a cost to hedging (there's derivatives trading involved after all) but I'm surprised that hedging comes at such a large cost. I'm certainly seeing the case for not bothering with hedging.

humble_pie: yes my first guess was also going to be the magic of CC's influence


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## andrewf (Mar 1, 2010)

The huge cost of currency hedging is not well covered. Many people still talk about taking 'currency risk' by owning foreign equities without hedging, when it reality, it seems like hedging actually increases your risk. I think people get confused about holding real (stocks, commodities, real estate) vs nominal (ie, bonds, cash) assets denominated in a currency. There only seems to be a case for hedging the latter, and even then I wonder if it is worth the cost.


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## james4beach (Nov 15, 2012)

I must admit that I used to be a fan of the currency hedged index exposure before I knew what kind of performance penalties were involved.

One of the ETFs that I really regret pitching to my parents was XIN (now I can't convince them to get out of it, since they insist on holding onto losing positions)

Just going by the performance page it seems to have an average delta similar to XSP, though there was one particularly brutal year with -5.3% worse than its index in 2009. Also when I look at the financial statements I notice tons and tons of currency derivative trades (as one would expect, when they have so many currency pairs to "hedge"). It seems reasonable to expect that many OTC currency swap trades, on many currency pairs, would involve inefficiencies, bid/ask spreads, etc.


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## james4beach (Nov 15, 2012)

Gosh, CanadianCapitalist has looked into everything including XIN in this article of his
http://www.canadiancapitalist.com/performance-of-the-currency-neutral-msci-eafe-index-fund/

In 2009, XIN underperformed the index by 6.6% !!! Totally unacceptable. That's such a huge difference than it makes me wonder if one of iShare's currency derivatives blew up during the financial crisis. Perhaps their counterparty was Lehman or something. Each of the currency swaps is an OTC contract, against a specific bank counterparty. Currently most of the counterparties are BNP Paribas and Deutsche Bank.


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## andrewf (Mar 1, 2010)

If a counterparty defaulted on a swap, wouldn't they have had to disclose it?


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## james4beach (Nov 15, 2012)

I don't know enough about accounting regulations. But this gets into why derivatives make me nervous, because things like this (Level III assets, limited disclosure) are not clear & obvious. By the way in 2009 they also changed accounting regulations. As I recall, they relaxed the rules on mark-to-market so that companies no longer had to immediately recognize losses, even if Level III assets (such as forex swaps) plummeted in value.

Again I don't know if this is applicable to XIN or any of the ETFs, but I generally don't like seeing derivative exposure.


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## lonewolf (Jun 12, 2012)

The U.S dollar is the dominate currency in North America why not hold a little & play the more liquide spy. 

For safety the dominate currencies of each continent should be held.


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## andrewf (Mar 1, 2010)

Yeah, but lonewolf, when you own SPY, you don't own USD. You own the shares of a bunch of companies.


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## Sampson (Apr 3, 2009)

andrewf said:


> Yeah, but lonewolf, when you own SPY, you don't own USD. You own the shares of a bunch of companies.


well... to be a bit more accurate, oroducts like SPY always hold a little bit of cash... just saying.


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## andrewf (Mar 1, 2010)

I thought about that when I was writing, but decided to not hedge the statement.


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## Sampson (Apr 3, 2009)

I've always found it a drag to do so.


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## andrewf (Mar 1, 2010)

This is turning into a pointless exchange.


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## james4beach (Nov 15, 2012)

And it's getting harder to track the meaning.


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## james4beach (Nov 15, 2012)

XSP had a very bad year. I think it's good to remind everyone of the *huge cost of currency hedging*.

XSP is supposed to track the S&P 500 index but in CAD. The US index (looking at SPY) was up 18.4% for the year, but XSP was only up 15.2%. That's 3% worse than what it's supposed to do!

I charted the ratio XSP:SPY. Ideally, this should be a flat line and it was flat at the start of the year. But once market & FX volatility hit, you can see the impact -- a big tracking failure with rapid loss of value. The ratio continued to deteriorate through the year which I suspect is due to the ongoing FX pair volatility.

Avoid these currency hedged ETFs.


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## james4beach (Nov 15, 2012)

I also suspect that iShares / Blackrock is stretching the truth about the "tracking error" of these things. If you look at the iShares web site, they show the chart of XSP tracking the benchmark very well.

They claim that their "S&P 500 Hedged to Canadian Dollars Index (CAD)" benchmark returned 15.4% based on the charting function. Does anyone know how they are coming up with that number?

The $SPXTR is up 18.4% for the year, and SPY is up 18.3%. Despite this big performance loss, they claim they are tracking their benchmark perfectly.

*A possible explanation*: the prospectus, page 154, says the index is the S&P 500 hedged to CAD on a monthly basis. So it's possible that FX hedging has this inherent problem of failing to keep up with market and FX volatility, due to the monthly nature of hedging... over many days, hedging would be "off" until it's aligned once a month. Greater volatility means greater error in the hedging. This would mean S&P publishes this CAD hedged index, and iShares really does follow it faithfully, meaning the tracking is perfect.... but the result still sucks, because the index itself sucks (flawed by design).


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## Tostig (Nov 18, 2020)

Have you done a thorough historical analysis of all the available S&P500 index ETFs that are available to Canadians, both hedged and unhedged? These would have to include VFV, VOO and HXS and run several historical scenarios like:

1) rising CAD, rising S&P;
2) falling CAD, rising S&P
3) rising CAD, falling S&P;
4) falling CAD, falling S&P.

Unhedged funds would be expected to be losers when the CAD rises but big winners when the CAD falls I don't think you can draw any definitive conclusion with only 1 year of data.


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## andrewf (Mar 1, 2010)

CAD:USD exchange rate is basically mean reverting over longer period of time. So unless you have a crystal ball and know when it will rise or fall, you are better off with the investment that works well overall. If you do know which way currencies will swing, you're better off with forex trading.


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## james4beach (Nov 15, 2012)

Tostig said:


> Have you done a thorough historical analysis of all the available S&P500 index ETFs that are available to Canadians, both hedged and unhedged? These would have to include VFV, VOO and HXS and run several historical scenarios like:
> 
> 1) rising CAD, rising S&P;
> 2) falling CAD, rising S&P
> ...


I'm saying that XSP does not hedge currency properly. If it had _properly_ hedged currencies, XSP would have gone up 18.3%. Instead it did 3% worse. The whole idea of this ETF is that it's supposed to go up 18.3% along with the S&P 500 index, no matter how USD/CAD moves.

Whether hedging is a good idea is another matter. My immediate point here, and the chart I posted, shows that XSP does not properly currency-hedge the S&P 500 index. I pointed to the prospectus and made a guess at why that might be happening.

The currency hedged ETFs (like XSP and XIN) have been disasters. Even if you *want* currency hedging, these things are still doing significantly worse than the indexes they track.


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## MrBlackhill (Jun 10, 2020)

Since S&P 500 is a US index, the only way to track it perfectly is to buy an ETF in USD. Even if you buy an ETF in USD, as long as you get income in CAD, your investment won't track the performance of an investor buying an ETF in USD with his USD income.

XSP.TO will only be at near-perfectly correlated to S&P 500, but that doesn't mean it will have the same performance due to some volatility drag of how hedging works.

You better buy XUS.TO or VFV.TO or ZSP.TO or HXS.TO if you don't want to be hedged. There's also ZSP-U.TO, HXS-U.TO if you want to buy in USD and prefer them to SPY.

Basically, when CAD/USD goes down, XUS.TO will outperform XSP.TO and when CAD/USD goes up, XUS.TO will underperform XSP.TO.

Put SPY, HXS.TO and XSP.TO on a chart. You'll see that HXS.TO beats SPY and SPY beats XSP.TO.

The hedge performed well when the CAD/USD was going down (look at 2012 to end of 2015, XSP.TO follows SPY, while HXS.TO totally outperforms).
The hedge did not perform well when the CAD/USD was going up (look at 2016 to end of 2020, XSP.TO is lagging SPY, while HXS.TO is underperforming).

Currency hedge ETFs will be highly correlated, but will suffer some volatility drag even if the goal is to reduce the volatility. Non-hedged ETFs will how a lower correlation, but may outperform or underperform.

I personally prefer non-hedged.



https://www.pwlcapital.com/sp-500-etfs-to-hedge-or-not-to-hedge-that-is-the-question/







Understanding Currency Hedging | Education | CI First Asset


CI Global Asset Management, a leading provider of Exchange Traded Funds (ETFs) in Canada, offers a comprehensive suite of ETF solutions. Rooted in strong fundamentals, the diverse and specialized lineup of ETFs strive to deliver better risk-adjusted returns than the broad market while helping...




www.firstasset.com







> When we add currency hedging to an S&P 500 Index portfolio, simple logic dictates that we should expect to receive in Canadian dollars the same return obtained by investors in U.S. dollars, since the objective of the hedging transaction is specifically to offset the effect of exchange rate fluctuations. However, in reality, things are more complicated.
> 
> First, forward contracts used to hedge currency risk are traded based on the current exchange (or “spot’’) rate, but they also integrate a component to take account of the difference in the interest rates in Canadian and U.S. dollars. In short, when the Canadian rates are higher than the U.S. rates, the hedging transactions will add some return to the funds, and vice-versa when the U.S. rates are higher.
> 
> The other factor that creates a difference between the returns of hedged versus unhedged funds calculated in U.S. dollars is the residual-currency effect. Generally, when the U.S. stock portfolio and U.S. dollar fluctuate in the same direction, the hedged funds will surpass the unhedged funds calculated in U.S. dollars. The reverse is true where the U.S. stock portfolio and U.S. dollar fluctuate in opposite directions.


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## Tostig (Nov 18, 2020)

james4beach said:


> I'm saying that XSP does not hedge currency properly. If it had _properly_ hedged currencies, XSP would have gone up 18.3%. Instead it did 3% worse. The whole idea of this ETF is that it's supposed to go up 18.3% along with the S&P 500 index, no matter how USD/CAD moves.
> 
> Whether hedging is a good idea is another matter. My immediate point here, and the chart I posted, shows that XSP does not properly currency-hedge the S&P 500 index. I pointed to the prospectus and made a guess at why that might be happening.
> 
> The currency hedged ETFs (like XSP and XIN) have been disasters. Even if you *want* currency hedging, these things are still doing significantly worse than the indexes they track.


I simulated a Canadian dollar portfolio with 10,000 CAD invested in SPY and in XSP each at the open of January 2, 2020. The stock prices and CAD/USD exchange rates came from Yahoo Finance Historical data. By the close of December 31, 2020 including all dividends SPY increased by 16% and XSP by 15.33% - both not even close to the 18% you state. Their differences (0.67%) is worth $67 which can be even smaller because brokerages gives you less during the exchange than the market for the conversion of SPY from USD to CAD.

So I don't think XSP is that far off.


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## james4beach (Nov 15, 2012)

Tostig said:


> I simulated a Canadian dollar portfolio with 10,000 CAD invested in SPY and in XSP each at the open of January 2, 2020. The stock prices and CAD/USD exchange rates came from Yahoo Finance Historical data. By the close of December 31, 2020 including all dividends SPY increased by 16% and XSP by 15.33% - both not even close to the 18% you state. Their differences (0.67%) is worth $67 which can be even smaller because brokerages gives you less during the exchange than the market for the conversion of SPY from USD to CAD.
> 
> So I don't think XSP is that far off.


I don't think you are analyzing this correctly. CAD exchange rate doesn't factor into this. What the hedged XSP is supposed to do is provide the same return as the S&P 500, but in CAD instead of USD.

Yahoo Finance shows the SPY year-to-date total return as 17.63% in USD. This is the goal... it's what XSP is supposed to return in CAD.

Yahoo Finance shows XSP.TO returned 14.56% in CAD

It's showing that XSP should have returned around 18% but instead returned closer to 15%. The exchange rate has nothing to do with what the ETF is expected to return. That's the whole point of the "hedged" ETF. It's supposed to give the same return as the index, but in CAD.


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## Tostig (Nov 18, 2020)

james4beach said:


> I don't think you are analyzing this correctly. CAD exchange rate doesn't factor into this. What the hedged XSP is supposed to do is provide the same return as the S&P 500, but in CAD instead of USD.
> 
> Yahoo Finance shows the SPY year-to-date total return as 17.63% in USD. This is the goal... it's what XSP is supposed to return in CAD.
> 
> ...


You're right. I ran the numbers again.

SPY in USD including dividends increased by 17.32%, 15.28% in CAD.
XSP increased by 14.49% which appears to be the results of an unhedged fund.

So just for fun, I ran VFV.TO (unhedged) and got 14.73%.
VSP.TO (hedged) 14.44%

Throughout that time, the CAD increased from 0.7707USD to 0.7843.


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## off.by.10 (Mar 16, 2014)

So, hedging has a cost. That cost is greater in times of high volatility. And where there's a cost, someone else is probably making boatloads of money.

Sounds about right? I am certainly thankful I learned about it several years go. It's good thing to bring it up again. Everyone using index funds should know about this.


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## MrBlackhill (Jun 10, 2020)

james4beach said:


> What the hedged XSP is supposed to do is provide the same return as the S&P 500, but in CAD instead of USD.


The link I provided explains why it won't. In fact, it's totally illogical to expect two ETFs - one in USD and the other in CAD - to return the exact same performance, even if it's hedged. You would need continuous hedging which is not possible.

Here's the link again and I'll summarize the explanation here. https://www.pwlcapital.com/sp-500-etfs-to-hedge-or-not-to-hedge-that-is-the-question/

Say the fund manager has a US$100M portfolio holding S&P500.
To hedge, he gets a forward contract of US$100M against CAD.

Now say the portfolio generates +3% during the month, so it's now worth US$103M. Therefore, there's now US$3M which are not hedged, while the initial US$100M is hedged by the forward contract.
If the USD increases +3% during that same time, the hedged portfolio will be worth US$103M + 3% of US$3M = US$103.09M, which is an increase of +3.09% instead of S&P 500's +3%.
If the USD decrease -3% during that same time, the hedged portfolio will be worth US$103M - 3% of US$3M =US$102.91M, which is an increase of +2.91% instead of S&P 500's +3%.

See, you can't hedge perfectly and the more volatility there is, the worse will be the tracking.


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## james4beach (Nov 15, 2012)

off.by.10 said:


> So, hedging has a cost. That cost is greater in times of high volatility. And where there's a cost, someone else is probably making boatloads of money.
> 
> Sounds about right? I am certainly thankful I learned about it several years go. It's good thing to bring it up again. Everyone using index funds should know about this.


Yes that sounds right to me.

I'm also glad I learned about it years ago. I switched to ZSP as soon as I learned. Thanks to Canadian Capitalist, the founder of this site, for discovering this effect and publishing articles about it.



MrBlackhill said:


> See, you can't hedge perfectly and the more volatility there is, the worse will be the tracking.


I agree, they can't achieve the intended goal perfectly.

The tracking error is really huge on these things. Over the longer term, looking at 15 year data of XSP vs IVV, the "cost of hedging" has been 1.7% annually

Even if someone likes the idea of hedging, that's a huge cost. I don't think any investor can afford to give up 1.7% in annual performance. And yet there's $6.5 billion invested in XSP!


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## Tostig (Nov 18, 2020)

Try THU.TO. I went shopping and found it. It's hedged and the 1 year return is 16.62%.

But the average volume is only 2,478.


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## MrBlackhill (Jun 10, 2020)

In my opinion - and correct me if I'm wrong - I don't know why I would use an hedged ETF. When available, I would always prefer the unhedged version.

After all, when our CAD decreases, the return on our unhedged investment increases. So, when the money you use everyday to buy stuff is losing power against USD, you are actually making more money with your savings. On the other side, if our CAD increases, the return on our unhedged investment decreases, but our CAD has more power. It's as if we were already "hedged" in some sense, it's balancing out. Why buy an hedged ETF?

Look at the drop of our CAD from 2013 to 2017. USD became so expensive. Meanwhile, ZSP.TO averaged 22.85% CAGR whereas SPY averaged 14.23% CAGR.

You are actually compounding the USD/CAD return with the unhedged CAD holding S&P500. SPY's 14.23% compounded with DLR's 7.95% equals 23.31%, which is a rough estimation of ZSP's 22.85%.





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## Tostig (Nov 18, 2020)

I did a one-year analysis of Nasdaq ETFs as well.

QQQ: 43.13% (USD); 40.67% (CAD)
CAD/USD: 1.97%
Hedged:
XQQ:42.57%
ZQQ: 42.66%

Unhedged:
HXQ: 43.44%
ZNQ: 42.13%

So it looks like the being less than 1% off, the hedged etfs for the Nasdaq didn't do as badly as the hedged etfs for the S&P500.

But I still think one year is just too short to draw a conclusion and 2020 was a very volatile year.


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## MrBlackhill (Jun 10, 2020)

I know the main subject here is about the hedge drag, but I wanted to post this video about hedging vs not hedging for Canadian investors.

For Canadian investors, not hedging reduces risk
Performance of hedging vs not hedging is not significant, with a very slight advantage to unhedged for longer time spans.

My conclusion remains the same. I'll prefer non-hedged ETFs.


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## MrBlackhill (Jun 10, 2020)

(Post duplicated)


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