How a falling loonie affects US equity ETFs

Over the last year the loonie has declined significantly relative to the US dollar: the currencies were at par early last February, but the Canadian dollar closed under $0.92 US on January 10. That has been a benefit for Canadians who hold US equities: not only did the stocks deliver huge returns in their local currency in 2013, but we got a further boost thanks to the appreciation of the US dollar.

Unfortunately, the drop in our dollar has encouraged some ETF investors to attempt to exploit a buying opportunity. Trying to make currency plays is foolish at the best of times, but it’s especially unwise if you don’t fully understand how currency exposure works.

Meet Gerry, who uses the Vanguard S&P 500 (VOO) to get exposure to US stocks. This ETF is listed on the New York Stock Exchange and trades in US dollars. With the greenback riding high, Gerry plans to sell VOO and use the proceeds to buy an equivalent fund listed on the TSX: the Vanguard S&P 500 (VFV). Gerry tells his friends he’s selling US dollars high and buying Canadian dollars low while keeping his equity exposure the same. If the Canadian dollar eventually gets back to par, he’s going to switch ETFs again and make another tidy profit. Clever, isn’t he?

Not at all. Gerry’s strategy will just incur trading commissions, bid-ask spreads and currency conversion costs—and maybe realize a big capital gain—all while gaining absolutely nothing.

Understanding currency exposure

The problem is Gerry doesn’t understand that these two funds have exactly the same currency exposure. When you invest in foreign equities, your exposure comes from the underlying currency of the holdings, not the trading currency of the ETF. So whether he holds VOO or VFV, Gerry benefits when the Canadian dollar falls, and he suffers when it appreciates.

This idea might be easier to understand if we instead consider a single cross-listed stock, such as Royal Bank of Canada. A Canadian buying Royal Bank on the New York Stock Exchange in USD would not have any exposure to the US dollar, because the holding itself is denominated in CAD:

• Imagine the CAD and USD are at par when Gerry buys 1,000 shares of Royal Bank on the TSX for $70 CAD per share. His holding is worth $70,000 CAD.

• At the same time, his wife Sharon buys 1,000 shares of Royal Bank on the NYSE, where it is trading at $70 US. Sharon’s holding is valued at $70,000 USD.

• Now let’s say the loonie declines to $0.90 USD, but Royal Bank’s stock price remains at $70 CAD. In New York, the stock would now be trading at $63 USD.

• If Sharon sold her shares now, she would net $63,000 USD, which is a 10% loss in USD terms. But although Sharon has fewer US dollars than when she bought the stock, each is worth more CAD. And as a Canadian, she likely measures her investment returns in Canadian dollars. In CAD terms, her investment return is zero—just as it is for Gerry.

US stocks mean USD exposure

The same principle holds with VOO and VFV, which have identical underlying holdings denominated in USD. If Gerry owned VOO, he would have noticed it reported a 2013 return of 32.33% in US dollars:

But as a Canadian investor, Gerry would have benefited from the appreciation in the US dollar, which rose about 6.29% in 2013. When calculated in Canadian dollar terms, his holding in VOO was up 40.65%.

And if Sharon owned VFV, she would have visited Vanguard Canada’s website and found that her holding also returned 40.65% last year:

So if you measure your returns in Canadian dollars, it makes no difference whether you use VOO orVFV. Their holdings—and therefore their exposure to USD—are exactly the same, even though the ETFs trade in different currencies.