# Hedged or Unhedged ETF's?



## Belguy (May 24, 2010)

If you hold ETF's in your portfolio, do you prefer to hold the unhedged versions and therefore pay less in fees or the generally higher fee hedged versions?

The Toronto Star's Bill Carrigan, in his column today, talks about "the investment myth of currency hedging". He includes a chart showing the monthly closes of the Canadian dollar spanning about 12 years, noting the big commodity-based advance of 2003 to 2007, followed by five years of flat price congestion that could drag on for several more years.

He concludes that "clearly since the Canadian dollar price peak of $1.10 in November 2007 (!!!!!), there has been NO benefit to owners of Canadian-dollar-hedged products over the past five years".

He then states that, "when we diversify by country, we also need to diversify by currency".

Would you tend to agree with him?


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## GoldStone (Mar 6, 2011)

>>> Would you tend to agree with him? 

Yes


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## Jungle (Feb 17, 2010)

If the Canadian dollar goes up, then hedged products will benefit? 
If the Canadian Dollar goes down, then non-hedged products will benefit?


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## andrewf (Mar 1, 2010)

The cost of hedging currency isn't even reflected in the MER. Hedged funds tend to lag because of the same compounding effects that you see with commodity futures ETFs, albeit on a smaller scale. Ie, if CAD goes from 1.00 to 1.10 and back to 1.00, the unhedged fund loses no value, but the hedged fund loses ~1%. Why? Because these funds are really hybrid equity+commodity ETFs.


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## longinvest (Sep 12, 2012)

Hi andrewf,
Could you explain the equity+commodity thing? Thanks.


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## Belguy (May 24, 2010)

When I rebalance my portfolio in the New Year, I plan to convert any of my ETF's which are currently hedged into the non-hedged variety.


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## Navigate Sensibly (Oct 24, 2011)

Belguy said:


> When I rebalance my portfolio in the New Year, I plan to convert any of my ETF's which are currently hedged into the non-hedged variety.


Me, too. I plan to do so as well.


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## andrewf (Mar 1, 2010)

SPY is a CAD-hedged S&P 500 fund. It is an equity fund in that it holds shares in S&P 500 companies. It is a 'commodity' fund in that it holds derivatives that give it effectively -100% USD:CAD exposure, either through futures contracts or swaps. This is how many other commodity funds work.


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## Spudd (Oct 11, 2011)

SPY is an American ETF, maybe you're mixed up with another ticker symbol?


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## andrewf (Mar 1, 2010)

Sorry, XSP--the iShares Hedged to CAD S&P 500 ETF.


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## HaroldCrump (Jun 10, 2009)

A hedged ETF is essentially a long position in the underlying securities and a short position in the currency of the underlying.
i.e. long S&P stocks, short USD/CAD.

You can (conceptually) create your own quick-and-dirty "hedge" by buying a lower cost S&P ETF in USD and then taking out a USD loan of the equivalent amount.
The interest you would pay on that loan (which should be pretty low these days) would be your cost of hedging.

Keep in mind that hedging (DIY or outsourced to the ETF) only cancels out the currency fluctuations.
It does nothing to protect you against precipitous drops of the underlying securities.


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## CanadianCapitalist (Mar 31, 2009)

HaroldCrump said:


> You can (conceptually) create your own quick-and-dirty "hedge" by buying a lower cost S&P ETF in USD and then taking out a USD loan of the equivalent amount.


The hedging is done by borrowing USD and parking it in a CAD account, so the cost of the hedge (for institutional investors) would be the interest rate differential between the two currencies. 

Unfortunately, hedging isn't perfect. Consider this example. S&P 500 is at 1,000. 1 CAD = 1 USD. One month later, S&P 500 goes up to 1,100. 1 CAD = 1.05 USD. Assuming, IRD is zero, CAD pays 0% interest and one month borrowing. Here's what has happened:

in USD gain = 10%
unhedged in CAD gain = 4.7%
hedged in CAD gain = 9.5% (S&P 500 = $1,100 USD; Borrowed funds = -$1,000 USD; CAD funds = $1,000)

You can work this out for three other scenarios (S&P 500 goes down & CAD goes up, S&P 500 goes up & CAD goes down and S&P 500 goes down & CAD goes down). What you'll find is that when the S&P 500 and CAD moves in the same direction, hedging will have a shortfall. And when S&P 500 and CAD move in opposite direction, hedging will show a gain. 

That doesn't sound so bad and gives the impression that hedging is advantageous in certain circumstances and disadvantageous in others. Unfortunately, S&P 500 and CAD tend to move in the same direction. How many times have you seen S&P 500 moving up and CAD strengthening? Or the US stocks falling and USD strengthening? Because of this, in the past hedging has resulted in a substantial lag with the underlying of the order of 1.5% annualized.

If you want to noodle around with various assumptions, you may be interested in a post I did on this topic:

http://www.canadiancapitalist.com/comparing-currency-hedged-and-unhedged-holdings/

Also, you can learn more than you probably want to know about hedging from the posts I've done over the years covering this topic:

http://www.canadiancapitalist.com/category/investing/currency-hedging/


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## Belguy (May 24, 2010)

And so, CC, when all is said and done, you know more than many of the rest of us when it comes to the subject of hedging. Therefore, it would be interesting to know whether you personally invest in hedged or unhedged ETF's.

Whatever you do is good enough for me!!


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## GoldStone (Mar 6, 2011)

Belguy, I think you are quite a bit older than CC. If CAD goes up 20% against USD in the next 5 years, the value of your USD investments will drop 20% (assuming flat investment returns). What is it going to do to your retirement lifestyle?


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## Belguy (May 24, 2010)

And so, could we draw this conclusion: If you are already retired and depending on your portfolio returns to determine the quality of your retirement, then you should invest in hedged versus unhedged ETF's or is the answer that simple?


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## GoldStone (Mar 6, 2011)

The rule of thumb is, the currency of your assets should match closely the currency of your liabilities.

If you need all of your assets to meet all of your liabilities, you have two choices:

1. consider currency hedging
2. eschew foreign currency investments altogether.

Note however:

Even if you spend 100% of your time in Canada, some of your expenses are still exposed to foreign currencies. Think of all imported goods you consume (e.g. Florida oranges). If CAD drops, the price of those imported goods will go up. So you still want to have some foreign currency investments as a hedge. 15-25% perhaps.


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## Jungle (Feb 17, 2010)

What about products like hxs that would have no hedging tracking error? (ignoring the counter party risk)


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## andrewf (Mar 1, 2010)

Depends on whether the hedging tracking error is built into the index. The XSP tracks an index that builds in the tracking error due to compounding losses on the hedge.


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## CanadianCapitalist (Mar 31, 2009)

Belguy said:


> Therefore, it would be interesting to know whether you personally invest in hedged or unhedged ETF's.
> 
> Whatever you do is good enough for me!!


I do not think the hedging debate has a clear answer. It is true that hedging can lag the underlying returns substantially. It is equally true that hedging would provide protection against a massive depreciation of the underlying currency. Hedging would probably have been a winner provided one was astute enough to do it when the CAD was (in hindsight) massively undervalued. Unfortunately, hedging became popular only *after* the bulk of the appreciation of the CAD was done.

Personally, I do not hedge my currency exposure. I'm willing to assume the risk of a large appreciation in the CAD because I think such a risk is very low from current levels. And I like the advantages that not hedging provides: cost savings of the order of 1.5 percent per year and lower volatility. YMMV.


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## CanadianCapitalist (Mar 31, 2009)

andrewf said:


> Depends on whether the hedging tracking error is built into the index. The XSP tracks an index that builds in the tracking error due to compounding losses on the hedge.


+1. The S&P 500 CAD hedged TR index that HXS tracks itself has a lag with the underlying returns due to the nature of hedging. HXS will help an investor eliminate the tracking error with the index but not the lag of the index itself.


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## andrewf (Mar 1, 2010)

Picking whether to hedge or not based on expected future currency fluctuations is another form of market timing. Depending on what you think of market timing, this can be just fine or something to be avoided. In the long run, exchange rates tend to be mean reverting, so you're paying for insurance you don't need. If you are concerned about currency exposure, maybe you need to reduce your overall risk.

Hedging when CAD is undervalued can be used to try and take advantage of this mean reversion. I don't know many sources who think CAD is currently undervalued, though.


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## longinvest (Sep 12, 2012)

Thanks guys. I've learned a lot from this thread.


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## james4beach (Nov 15, 2012)

There's the theory of hedging (use currency derivatives to eliminate currency exposure) and then there's *hedging in practice*. It doesn't always work out so well in practice, that is, hedging is not always achieved.

The best example that comes to mind is XIN, the hedged MSCI ETF. After noting its poor performance versus EFA (the same fund in USA, non-hedged) for a few years I started digging further into the numbers to see if it's really underperforming, or I'm observing the hedging in process. These things can become difficult to compare because there's also internal reinvested distributions.

What I found is that whether you take into account base currency or hedged currency, XIN underperforms in the 5+ year scale. Digging into the fund further, you'll see that it actually holds a ton of currency swap derivatives. Not just for USD of course but also EUR, JPY, and many others. This fund contains a huge number of currency derivatives and incurs a huge number of derivative trades in any given year.

And I think this explains what happened with XIN performance. Each of those derivatives (which are not market instruments by the way) incurs cost: both the trading cost, but also the money lost due to the spread on illiquid contracts. And then there's the issue of how good their traders are, and whether they are trading nimbly enough to match the fund's exposure. Given that XIN trades in and out of a ton of different derivatives, it's safe to assume that they're leaking away money in doing so... and I think that explains how XIN's hedging has gone wrong in the long term.

Compare to say XSP, which hedges S&P 500 to CAD (only one currency), and beautifully tracks with excellent performance. While XIN contained a ton of derivatives with lots of trading, XSP contains very few --- just USD to CAD --- and very little trading activity. This is all visible in their annual financial statements.

So my advice:


Don't just trust an ETF is hedged well
Prefer ETFs that are hedged to just one currency, e.g. USD/CAD
Look at the extent of their derivative exposures, especially trading ACTIVITY
You can assume that more derivative trading translates to lower performance


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## andrewf (Mar 1, 2010)

Best advice: avoid hedging. It only adds value if you know which way currencies are going to move. And if you know that, invest in the forex market for profit.


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