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Don’t Follow The Crowd Into The Wrong Index Funds
March 02, 2015

Don’t Follow The Crowd Into The Wrong Index Funds

There's a mantra that Wall Street would probably like to banish. If it sounds too good to be true, it probably is. Wall Street, after all, will sell what Wall Street can sell.  Such is the case with currency hedged Exchange Traded Funds.

 Reuters says that this year, they're popular.  But among 12 year old girls, so is Justin Bieber.

A currency hedged ETF is an international index that is supposed to protect investors from currency swings.  For example, assume you own a European stock market index.  If the stocks within the index gain 10 percent (measured in Euros) you would expect your index fund to earn something similar.  But reality could be different. If the Euro drops 10 percent, compared to the U.S. dollar, Americans wouldn’t profit.  A currency hedged ETF, on the other hand, would still make money for American investors.  At least, that’s the sales pitch.

Currency fluctuations, however, aren’t always bad. If, for example, the U.S. dollar falls against most foreign currencies, then investors could profit from a non-hedged international index, as the growing strength of foreign currencies, against the dollar, juice the returns of a foreign stock index in U.S. dollars.

With a diversified portfolio of domestic and non-hedged international stock indexes, sometimes you’ll win when currencies fluctuate.  Sometimes you’ll lose. If the international market drops 5 percent, but the U.S. dollar drops 8 percent against international currencies, Americans gain money if they’re invested in an international stock market ETF. On the flip-side, if the international market drops 5 percent but the U.S. dollar gains 8 percent against the index’s foreign currencies, the same investors would lose about 13 percent.

Currency hedged ETFs are made to help you sleep.  They limit fluctuations. But they have their own set of problems.  First, their management fees are higher than with plain vanilla indexes.  Second, they have higher hidden costs associated with the hedging itself.  Finally, investors buying them often gamble that foreign currencies will lose to the U.S. dollar. 

Currency hedged ETFs weren’t always common in the U.S. Other countries, however, have had them for years.  Canadians, for example, couldn’t even buy a non-hedged international stock ETF just a handful of years ago. But Canadians have learned that they’re no panacea.

In a PWL Capital research paper, Raymond Kerzérho examined the returns of S&P 500 indexes hedged to the Canadian dollar between 2006 and 2009. Even though the funds were meant to track the index, they did much worse.  They underperformed the S&P 500 by an average of 1.49 percent per year.  Currencies were less volatile between 1980 and 2005.  During that period, tracking errors caused by hedging would have cost 0.23 percentage points per year.  Add the higher expense ratios of currency hedged funds and they would have underperformed non-hedged funds by about 0.5 percent a year.

The more cross-currency transactions that a fund makes, the higher its expenses – because even financial institutions pay fees to have money moved around. Consider the example of a currency exchange booth at an airport. Take a $10 bill and convert it to Euros. Then take the euros they give you, and ask them to return your $10. You’ll get turned down. The spreads you pay between the “buy” and “sell” rates will ensure that you come away with less than $10.

Large financial institutions don’t pay such high spreads.  But they still pay them.  And they reduce investors’ returns.

Then there’s the opportunity cost from the hedging itself. Mr. Kerzeho provides an example of a theoretical S&P 500 fund hedged to the Canadian dollar. Assume that it has $100-million (U.S.) in assets under management. At the beginning of the month, it would be long $100-million in the U.S. S&P 500. At the same time, it would be short $100-million – in U.S. dollars – in foreign contracts versus the Canadian dollar.

If the U.S. index gained 3 percent for the month, then it would be long $103-million (because of the rise in the U.S. market). Considering that $100-million was short as a currency hedge, it would leave $3-million exposed and unhedged. If the U.S. dollar drops, the $3-million in unhedged dollars will depreciate.

Because most financial institutions adjust their hedging once per month, fluctuations in currencies ensure that part of the assets are always underhedged or overhedged. If, for example, the S&P 500 lost money over the course of a month, then the fund would become overhedged. Using the figures above, if the $100-million long position dropped 3 per cent to $97-million, the fund would be overhedged by $3-million – exposing it to potential losses on currency movements.

Ben Johnson published results from a 20 year U.S. study in Morningstar.  He says non-hedged ETFs usually beat their currency hedged counterparts. “By hedging foreign-currency exposure, investors can mitigate a source of risk--but at the expense of a potential source of return.”

Currency hedging doesn’t pay, long term.  So don’t follow the crowd with the wrong kind of fund.

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