As I pointed out in my previous post, equity markets around the world lost quite a bit of value in the third quarter of 2011. However, the Canadian dollar also posted a significant loss against the US dollar and Japanese Yen and remained more or less flat against the Euro and the Pound. As a result, portfolios that held international stocks without hedging away the currency risk did not lose as much as portfolios that employed currency hedging. This is not a new phenomenon.
In a recent post (See Vanguard Canada initial ETF offering falling short), PWL Capital’s Justin Bender took a look at the risk and return characteristics of two balanced portfolios with significant foreign stock holdings. Both portfolios allocated 30% to the iShares S&P/TSX Capped Composite ETF (XIC) and 40% to the iShares DEX Universe Bond ETF (XBB) to gain exposure to Canadian stocks and bonds respectively. One portfolio allocated 15% each to two currency hedged ETFs: iShares S&P 500 CAD-Hedged ETF (XSP) and iShares MSCI EAFE CAD-Hedged ETF (XIN). The other portfolio allocated 15% each to iShares S&P 500 ETF (IVV) and iShares MSCI EAFE ETF (EFA).
Mr. Bender found that between December 2005 and August 2011, the CAD-hedged portfolio posted slightly lower returns than the currency-unhedged portfolio (3.75% versus 3.81%). Interestingly, the Canadian dollar was valued at USD 0.8557 in December 2005 and at USD 1.0221 in August 2011. In other words, the currency-hedged portfolio underperformed the unhedged portfolio even though the Canadian dollar appreciated 19% against the US dollar. During the same time period, the Canadian dollar lost 3% against the Euro, lost 24% against the Yen and gained 27% against the Pound Sterling.
The currency unhedged portfolio was also much less volatile. The Standard Deviation of the unhedged portfolio was 7.9%, significantly less than the 9.3% SD of the CAD-hedged portfolio. A graph of the 3-year rolling SD shows that the CAD-hedged portfolio is consistently more volatile.
ETF vendors should take note of these findings and instead of launching even more CAD-Hedged ETFs, they should be focusing on providing investors with more (and better) choice in the form of broad market ETFs that directly hold foreign stocks or ETFs.
