Saturday, 7 April 2007

Is Currency Hedging on Foreign Equity Too Expensive?

Someone named George$ wrote a very pertinent post on the Financial Webring asking what people think of the Globe and Mail article by Allan Robinson in which several major fund managers like Franklin Templeton and Fidelity Investments say they do not do currency hedging on their international equity funds to eliminate the effects of foreign exchange shifts because it is not worth it. I've replied to George$ on the site, where hopefully others will comment too, but here is my reply. This is an important question for anyone who wants to use international investments, whether equities or fixed income, to diversify and reduce risk.

I'd sure like to see those studies done by Templeton because there can be very long term trends between currencies, for example the Canadian vs the US dollar. In the ten years from January 1997 to April 2007, the CDN$ went from 0.73 to 0.87 a 20% increase and from 0.62 to 0.88 in the five years between November 2001 and November 2006, a 42% increase. That would be enough to wipe out a substantial chunk of the US market gains for a Canadian investor. How long does the investor have to wait for currency fluctuations to even out and what is to be done in the meantime if the investor needs to cash in? Is Templeton referring to the situation of a large number of currencies with a very broad portfolio such as the MSCI EAFE index? But then, iShares Canada sells the XIN fund that mirrors the MSCI EAFE index and is 100% hedged to CDN$. Its MER is 0.15% - quite reasonable. The similarly hedged XSP mirroring the S&P 500 also has a 0.15% MER. In the end I ask myself, why do I want to bet on the currency as well as the foreign stock/index if I can avoid doing so at a reasonable cost.

One possibility I cannot admit to having modeled or seen done by someone else is the effect of re-balancing under an asset allocation policy. That would have one pushing more funds into markets when the exchange rate changes, a kind of dollar cost averaging. Not sure if that would reduce or completely eliminate the currency effect over time. Anyone have a view?

I've previously posted other comments on this question on my blog.

I wish Allan Robinson had gone to see the iShares folks but it was good to read anyway.


Anonymous said...

I agree that you cannot assume that exchange rates will wash out over your investment timeframe. What we need access to is ETFs like the CurrencyShares product in the United States, but for the Canadian Dollar and its currency pairs. If you buy $X in currency Y investments and can short the currency ETF the same (or nearly same) amount, then you effectively negate your currency risk (less MER's, etc.). To me this ideal, since investors can choose whether they want to hedge or speculate on future currency rates.

Anonymous said...

One minor correction: MER on XIN is 0.50% because it really owns EFA which charges an additional 0.35%.

My view is that hedging currency now is performance chasing. Hardly anyone hedged their USD exposure five years back. Why? They thought the C$ was a Northern peso. Today, the crowd is saying that USD is going down the tubes. Why should they be right now?

My investment horizon is 20+ years and I think I'll be investing some years when the C$ is 70 cents and some years when the C$ is 90 cents and overall it will balance out. Not to mention, US-listed companies with significant international operations themselves hedge their exposure. Do we need a hedge on top of a hedge?

CanadianInvestor said...

Yes, you are right about the extra fees. I've done some investigation and a worse thing about XIN is the tracking error, meaning the amount by which XIN under-performs its reference index EFA. XIN's under-performed EFA by 1.33% in the year ending March 31, 2007 and due to the nature of tracking error, there will always be some under-performance relative to EFA, over and above the MER fee.

There was a very useful discussion on the Financial Webring under General Finance / Currency Hedging - Pros and Cons. Good reading!

There's one post I made in there referencing a paper by a fellow named Mark Kritzman who crunched some numbers and found that currency exposure for a Canadian portfolio is actually beneficial due to negative correlation / diversification effects. So I'm becoming more convinced that holding EFA instead of XIN may be the better choice.

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