Currency exposure in international equity ETFs

My last post explained that Canadian investors are exposed to currency risk any time they hold US equities, even if their holding is an ETF or mutual fund that trades in Canadian dollars.

In my example, Gerry owned the Vanguard S&P 500 (VOO), which is listed on the New York Stock Exchange and trades in US dollars, while his wife Sharon owned the Vanguard S&P 500 (VFV), which trades on the TSX in Canadian dollars. Since the underlying holdings of both ETFs are the same—500 large-cap US stocks—both Gerry and Sharon have the same exposure to the US dollar, even though they’re trading in different currencies. (The exception would be if one chose an ETF with currency hedging, such as the Vanguard S&P 500 CAD-hedged (VSP), which is designed to eliminate currency risk.)

If that idea is confusing, it gets even more fun when you add international equities to the mix. Let’s say Gerry owns the Vanguard FTSE Developed Markets (VEA), an ETF that trades in US dollars and holds stocks from western Europe, Japan, Korea, Australia and many other overseas countries. Sharon owns theVanguard FTSE Developed ex North America (VDU), the TSX-listed version of the same fund, which trades in Canadian dollars. Which currencies are Gerry and Sharon exposed to now?

Remember, your currency exposure comes from the fund’s underlying holdings, not from its trading currency. The stocks in VDU are denominated in a basket of overseas currencies: the euro, pound, yen, Swiss franc, Australian dollar, and others. So if the Canadian dollar appreciates against these currencies, Sharon’s returns will suffer, and if the CAD declines relative to them, she’ll get a boost. Easy enough so far.

But many investors are surprised to learn that Gerry has the exact same currency exposure as Sharon, even though his ETF is bought and sold in USD. The underlying holdings in VEA are exactly the same as in VDU, and the strength or weakness of the US dollar relative to the loonie will have no effect when Gerry calculates his returns in Canadian dollars.

A fair exchange

This is a confusing idea, so an example will help. Say you’re leaving for ski vacation in the Italian Alps when the euro (EUR) is worth $1.488 CAD, and the US and Canadian dollars are at par. The rates at the currency exchange counter look like this (assuming a spread of zero):

€1,000 EUR = $1,488 USD
$1,488 USD = $1,488 CAD
€1,000 EUR = $1,488 CAD

You have some US cash left over from your last trip to Florida and you decide to exchange $1,488 USD for €1,000 euros before you leave for Italy. When you return to Canada a few weeks later, you notice the CAD/EUR exchange rate is the same, but the loonie has fallen to $0.92 USD. The sign at the foreign exchange counter looks like this:

€1,000 EUR = $1,366 USD
$1,366 USD = $1,488 CAD
€1,000 EUR = $1,488 CAD

Now if you sell €1,000 EUR for $1,366 USD, you’ll feel like you’re losing $122, because you paid $1,488 USD for the same amount on your departure. But in Canadian dollars, your €1,000 is still worth exactly the same. As a Canadian buying and selling euros, you don’t need to be concerned about the USD/CAD exchange rate. Even if you use greenbacks to make both transactions, the effect of the CAD/USD exchange gets washed out in the transaction.

Trimming the hedge

The same idea is at work if you buy international equities: if you’re thinking about selling VEA and buying VDU because the US dollar is high relative to the loonie, you’re wasting your money. Neither fund is affected by the USD/CAD exchange rate, and all you’re doing is incurring unnecessary transactions costs.

If you are worried about an appreciating Canadian dollar you could choose an international equity fund that use currency hedging, such as the Vanguard FTSE Developed ex North America CAD-hedged (VEF). If the loonie moves up against several foreign currencies at once, hedging would offer a significant benefit. But those periods of high correlation are relatively uncommon. During 2013, for example, the Canadian dollar declined against the euro, the pound and the Swiss franc, but appreciated against the yen and Australian dollar (see chart above).

This is why paying for currency hedging in international funds is a dubious strategy: to some extent the currencies hedge themselves and actually provide some diversification benefit.