Investors buy into currency-hedged funds on the premise that they can obtain returns provided by foreign stock markets while avoiding the deleterious effects of currency movements. The promise of currency-hedging is especially alluring in the case of US stocks because investors would like the good (quality US companies in dynamic sectors not available in the Canadian market) without the bad (everyone “knows” the US dollar is going down the toilet). Investors mistakenly believe that they can have the good and avoid the bad by investing in currency-hedged funds by paying a smidgen more in expenses and fees.
The reality, as I’ve pointed out in previous posts, is quite different: currency-hedging funds significantly lag the returns of foreign equity investors year after year. 2010 turned out to be no exception. The iShares S&P 500 (Currency-Hedged) ETF (TSX: XSP) returned 13.42% in 2010. But a US investor who owned the iShares S&P500 ETF (NYSE: IVV) earned 14.79% when measured in US dollars. Therefore, a currency-hedged Canadian Investor experienced a shortfall of 1.37%.
It’s true that the XSP investor outperformed the Canadian investor holding IVV directly (who would have earned 8.73%) in 2010 due to the appreciation of CAD against the USD. But if you take a slightly longer term view and consider the fact that XSP has trailed IVV returns in US dollars every year for the past five years, you’ll find that XSP’s outperformance is significantly eroded by the tracking error even with a significant appreciation in the Canadian dollar.
Let’s look at this with a concrete example. An investor purchasing $1,000 worth of XSP at the start of 2006 would have ended 2010 with $984. A Canadian investor purchasing $1,000 worth of IVV would have first converted her Canadian dollars into US dollars. At the start of 2006, she would have invested $857 (US) in IVV, which at the end of 2010 would be worth $958 (US) or $952. The C$ has appreciated 17% in five years but the XSP investor is ahead of the IVV investor by only 3.3%.
As in previous years, the observation that currency-hedged funds trail the returns of US dollar denominated funds extends to the TD e-Series Funds. The TD e-Series US Index Currency Neutral Fund (Fund Code: TDB904) also trailed the US dollar returns of the TD e-Series US Index US$ (Fund Code: TDB952) by 1.65% in 2010.