Currency Hedging in International Funds

Currency hedging can be confusing for investors who use index funds and ETFs that hold foreign stocks or bonds.

The basic idea, which I have written about before, is not terribly hard to understand. If a Canadian buys an unhedged index fund that tracks US stocks, her returns will suffer if the US dollar declines against the loonie. (On the other hand, she’ll get a boost if the greenback appreciates.) If a fund uses currency hedging, however, you can expect the same return as the underlying stocks, regardless of the currency fluctuations.

But things get complicated when there is more than one foreign currency involved. The iShares MSCI EAFE Index Fund (XIN) covers more than 20 countries, and the stocks are denominated in British pounds, Japanese yen, euros, Swiss francs, Australian dollars and a few others. The hedging strategy is designed to eliminate the effect of fluctuations in all of these currencies compared with the loonie. So investors in XIN should expect the same return in Canadian dollars that local investors in Europe, Asia and Australia receive in their own currencies.

US funds rarely use hedging

I’m not sure why, but US-listed ETFs tend not to use currency hedging for international equities. As a result, Canadians who invest in funds such as the iShares MSCI EAFE Index Fund (EFA)—the US version of XIN—or Vanguard’s Vanguard MSCI EAFE (VEA) are fully exposed to the pound, euro, yen and other foreign currencies.

If you expect the Canadian dollar to remain strong against most or all of these overseas currencies, then it makes sense to use XIN. However, if you do not want to incur the added costs of hedging (or if you share my opinion that exposure to several currencies diversifies to your portfolio), then consider an alternative such as EFA or VEA.

Although these US-listed ETFs are cheaper than their Canadian counterparts, several investors have told me they avoid them because they don’t want to be exposed to the risk of a falling US dollar. Others have taken the opposite view, arguing that now is a good time to buy these ETFs, because the US dollar is so low.

No exposure to the US dollar

This confusion is understandable, since both EFA and VEA are bought and sold in US dollars. Remember, however, that the underlying stocks are denominated in a basket of overseas currencies. Therefore, the strength or weakness of the US dollar has no effect on the return that international equity ETFs deliver to Canadians.

I recently spoke with Vikash Jain, portfolio manager at archerETF, an investment firm with a global outlook. He clarified this idea using the example of a Canadian buying a US-listed ETF that holds stocks denominated in euros.

“You take your $100 Canadian and you convert it to US dollars to buy the ETF,” Jain explained. “Then the manager of the ETF is going to sell those US dollars and buy euros. Now you have bought US dollars and sold US dollars — so the transactions cancel each other out, and therefore you have no US dollar exposure. However, you sold Canadian dollars and you bought euros. So now you are negative Canadian dollars and positive euros. When you sell the ETF, it’s just the reverse process: the manger sells the euros and buys the US dollars, then you sell the US dollars and buy Canadian dollars.”

So if you’re adding international equities to your portfolio, take a good look at low-cost US-listed options, especially from Vanguard. You may incur added brokerage fees when you buy and sell these ETFs on the New York exchanges, but you will not be exposed to the US dollar in any way.